US equities, as measured by the S&P 500 Index, have had a phenomenal decade: 12.9% compound per annum returns between March 2014 and March 2024, increasing investors’ wealth 3.4 times over. At least part of this strong performance is fundamental: earnings growth has been strong (and superior to other developed markets), reflecting America’s business-friendly status and creation of some of the world’s greatest companies.
However, two-fifths (42%) of this has come from once-off sources: a higher price-to-earnings ratio and profit margin expansion. This is a historically unusual situation. Between 1924 and 2024, the majority of returns (88%) came from sustainable sources: earnings growth and dividends.
If, as we argue, the price-to-earnings ratio and profit margins are unlikely to contribute much in the future, then, on a 5-10 year view, an investor in the S&P 500 is left earning the sustainable sources of returns: sales growth, dividends, and buybacks.
The table below shows what we think these sustainable returns might be. Our base case forecast is for 6.0% compound per annum total returns, far below the historical norm of 10.6% compound per annum that investors have earned since 1924. It’s not much of a risk premium, either, over the 4.7% risk-free yield available from US 10-year government bonds.
Base case returns could be boosted by expansion in profit margins or the price-to-earnings ratio but, as we detail in later sections, this appears unlikely. Inversely, base case returns could be reduced by a contraction in profit margins or the price-to-earnings ratio. A contraction in the price-to-earnings ratio from current levels (28.5) to the average that has prevailed since 1983 (21.0) would reduce returns by 3% annually over a 10-year period.
Therein lies the rub: prospective S&P 500 returns of 6.0% annually come with significant downside risks, no obvious upsides, and a scant risk premium.
All of this matters, even to investors who just want a global equity portfolio. The US equity markets are so big that they account for nearly two-thirds of global equities.
We highlight that there are a number of ways to address the risk of sub-par returns from the S&P 500 Index, including global equity ETFs, equal-weighted ETFs, and actively managed global investment funds/trusts.
It is not our intention to underplay the success of business in the US – it’s achieved remarkable commercial success. However, there’s little arguing with the following: rising price-to-earnings ratios and expanding margins are once-off phenomena (particularly the former). The last decade of exceptional US equity returns is unlikely to be repeated.
A full copy of our recent note, “S&P 500: Calling The End of Outsized Returns” is available for subscribers on the website.
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Darren Gillen
Head of Research
10th May 2024
