What is the outlook for US stock market returns over the coming decade? There is no shortage of commentary on this topic, and I don't have any unique answers, but I thought I would share two graphs.
A lot of market commentary suggests the stock market is overvalued on the basis of measures such as stock market capitalization to GDP, Shiller's CAPE (10 Year Average Inflation-Adjusted PE ratio), Tobin's Q, etc. But for any elevated ratio, a reversion to the mean can occur via a combination of falling numerator and/or rising denominator. For example, GDP could grow rapidly while stock market valuation grows slowly, allowing the ratio of market cap to GDP to mean revert without a fall in earnings and stock prices. But how likely is the numerator to fall? That is what would most concern a medium to long term investor.
One prediction in particular that caught my attention was Robert Shiller's suggestion that the S&P 500 will be around 1430 in the year 2020. With the S&P 500 currently around 1300, that represents roughly a 10% total increase (not annual!) over a decade. Robert Shiller is known for recognizing both the dot-com bubble and housing bubble long before most people, so he is worth listening to.
Here is a chart of trailing 12 month reported earnings created from Shiller's spreadsheet, from 1871 through Q3 2010:
The green exponential trend line shows the long term earnings trend. Current earnings have rebounded quickly to well above the trend line. If earnings oscillate around this trend line as they have done historically, they should be centered around roughly $60 in 2020! At a 15 valuation multiple, that only represents an S&P 500 index value of 900 (a 31% decline!) However, this trend is for real (inflation adjusted) earnings, so the nominal level of earnings and corresponding S&P 500 valuation would be somewhat higher assuming continued positive inflation.
But what about the most optimistic case from the perspective of the stock market? What if we are in a sustainable new era in which the recent extraordinary corporate margins, earnings to GDP, etc, can be maintained indefinitely? The next graph shows the same trend line since 1980 but for nominal reported earnings. The red portion of the line is the estimated forward earnings from Standard & Poors S&P500 spreadsheet as of today, which is important because expected earnings represent what the market valuation is currently priced for, i.e., earnings of $90-$95.
This trend line shows the nominal earnings trend reaching the $90-$95 level around 2020. So current earnings and forward estimates are ten years ahead of "schedule"! This second graph seems to align with Shiller's suggestion of an S&P index of 1430 in 2020 (with a 15 valuation multiple, earnings would be $95).
The key question for a stock market investor is what happens to that earnings line over the next decade: does it remain above trend line (not impossible, if you look at the late 1990s period), does it crater again as in 2008-2009, or does something else occur?
This graph shows the extent to which nominal earnings can fall: a 35% fall from 1989-1991, a 54% fall from 2000-2001, and a 92% fall from 2007-2009 . So history shows that a falling numerator is not uncommon, i.e., reversion to mean not exclusively driven by a rising denominator. If falling earnings is a reasonably probable scenario, the next question is, when? With labor cost pressures low and held down by high unemployment, and rising commodities costs representing a possibly more manageable percentage of most cost structures, is a contraction in GDP the only thing that could meaningfully reduce earnings?
Comments are welcome.