For the past ten years, the S&P 500 has given us an annualized return of 13% versus the long term average of 9.9%. To what do we owe this munificence? With a little analysis, it is possible to break down the annual return into two components which Vanguard founder Jack Bogle labeled the “fundamental” return and the “speculative” return. The word speculative is something of a pejorative so I will call it the “sentiment” return. The fundamental return is the portion that is attributable to growth in corporate earnings which ultimately translates into higher dividends. The sentiment return results from changes in the price-earnings ratio which reflects the amount that investors are willing to pay for each dollar of earnings.
For the ten year period ending in December of 2024, S&P earnings grew at a 7.5% annual rate which means that the annual equity return would also have been about 7.5% had there been no change in the P/E ratio. (The fundamental return) However, the P/E rose from 20.08 to 28.45 resulting in the actual annual return of 13%. Said another way, improving investor sentiment accounted for 5.5% of the 13% return or about 42%.
The P/E incorporates investors’ collective sentiment which is by definition subjective and qualitative. As a result, we can only guess at the factors that led to the optimism reflected in the 40% increase in the P/E over this ten year period. However, a few candidates are:
- Interest rates were very low for most of this period which created a favorable environment for both corporations and investors.
- The economy has grown at a healthy 2.4% annual rate.
- The U.S. economy outperformed the rest of the world.
- Both monetary and fiscal policy have been highly stimulative.
- Investors are optimistic that AI and other technologies may result in an acceleration in future earnings.
- Balance sheets are in good shape for most large cap companies.
- The world is awash in liquidity.
Now for the bad news. Historically, there has been a powerful inverse relationship between the starting P/E and equity returns over the ensuing seven to ten years. With P/Es and other valuation metrics currently in roughly the 90th percentile of historical experience, we should therefore expect lower than average stock returns. Specifically, our firm’s official forecast is a 4.7% annual return for the next 7-10 years although I would not ascribe too much precision to that number. In any case, this forecast forms the basis of our decision to employ private real estate, private equity, private credit, and other similar strategies in portfolios of clients who qualify under SEC regulations and have the ability to tolerate a measure of illiquidity.