Over the past few months, the stock market indexes have been balanced precariously on a knife’s edge. Is this the precursor to a significant correction or merely a pause before stock prices resume their upward march? In the short term, no one knows. Ironically, it is easier to forecast stock returns over the next 20 or so years, and it doesn’t look good.
There is no question that stocks have richly rewarded long-term investors. As Jeremy Siegel points out in his book, Stocks for the Long Run, one dollar invested in the U.S. stock market in 1802 would have grown by 2001 to $8.8-million. Even if we back out inflation, that one dollar would still have grown to just under $600,000 over that period.
This translates into a real return of nearly 7 per cent, compounded annually, which shows the magic of compound interest. Over the past 30 years, that real return has been even higher at about 8 per cent.
Canadian statistics do not go back nearly as far, but one dollar invested in Canadian stocks in 1924 would still have grown to $445 by 2019 (after adjusting for inflation). While this sounds less impressive, it does translate into an annual real return of 6.6 per cent. All the returns cited above include dividends.
Given the long history of great returns, why can’t we expect this stellar performance to continue? There are two reasons, the first being demographics. The age distribution of the population is fundamentally different now than at any time in the past. Notwithstanding the benefits of immigration, we are aging, which means the proportion of seniors is much higher than it was, not just in Canada but globally.
An aging society is likely to lead to lower economic growth, and translate to lower earnings growth for the companies that make up the market. Consider Japan, for example. Its society is 20 years ahead of us on the aging curve and neither its economy nor its stock market has grown much since the 1990s. Japan’s major index, the Nikkei 225, is still lower than it was in 1989.
The other reason why stock prices will rise more slowly has to do with price-to-earnings ratios, the price of a stock divided by its annual earnings per share. P/E ratios are an indicator of how overvalued the stock market is in general. Let’s consider the P/E for the S&P 500 index since the data are more readily available than for Canada and extend further back into the past.
Historically, the P/E, based on trailing 12-month earnings, for the S&P 500 has fluctuated between 10 and 20 (see accompanying chart). Until recently, it has breached the ceiling of 30 only twice.
The first time (I regard the period 1998 to 2001 as part of the same event) coincided with the dot-com bubble, which burst in 2001. The second occurred just before the Great Recession of 2008-09.
The P/E for the S&P 500 is once again above 30, where it has been since January, 2020. In fact, it is closer to 35. I am not going to predict an imminent crash but I will suggest that the high P/E does not bode well for the medium term. That is because the scenarios in which stocks can continue to do well are rather far-fetched compared with the scenarios that would lead to lower returns.
Basically, future returns on stocks are dictated by the change in the P/E ratio. If the P/E is stable, real returns on all stocks have averaged about 7 per cent. This was the case up until 1990. When the P/E is rising, real returns can be higher and since 1990, a time when the P/E has doubled, real returns have averaged 8 per cent. It stands to reason that if P/E ratios decline significantly then real returns will also tend to decline.
For the next 20 or so years, consider the scenario in which the P/E ratio remains in the mid-30s. If it does, then we have every reason to expect real returns to remain around 7 per cent. If the P/E rises higher yet, then real returns could even exceed 7 per cent. The problem is, this scenario is highly unlikely since a P/E above 30 has never been sustainable at any time since 1900.
Now what if the P/E ratio drops gradually back to 25? This is actually quite an optimistic scenario given that the range used to be 10 to 20. Nonetheless, it would not be good for stock market returns. Assuming nothing unusual happens to profit growth, real returns would drop to about 5 per cent.
Even worse, imagine the P/E sliding all the way back to 20 and profit growth slowing by one percentage point a year. In that case, the future 20-year return on the S&P 500 would be just 3 per cent a year in real terms, which isn’t much on a risk-adjusted basis.
Unfortunately, there are few viable alternatives to investing in stocks. Bond returns will almost certainly be even worse and real estate investing is fraught with problems of its own. All of this suggests that anyone saving for retirement should start saving a little more. As for retirees whose saving days are behind them, they should be fine as long as their investment return expectations are modest.
Frederick Vettese is former chief actuary of Morneau Shepell (now LifeWorks) and author of The Rule of 30: A Better Way to Save for Retirement, which is being released Oct. 19.
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