US Stocks Have Had A Stellar Run, But They May Be Ready To Pass The Baton

US Stocks Have Had A Stellar Run, But They May Be Ready To Pass The Baton
Reda Farran, CFA

about 1 month ago8 mins

  • The S&P 500 is just off a remarkable ten-year run, outperforming cash by an annualized 11.9%. That’s an exceptional outcome that lies well above the 90th percentile of rolling ten-year returns across global developed market stocks since 1950.

  • Repeating that kind of performance would mean nailing some long-shot wins: both extraordinary real earnings growth and all-time-high valuations. And while that might not be impossible, it’s an implausible baseline assumption.

  • With that backdrop, you may want to consider reducing your exposure to the US and shifting toward more attractively valued regions, like (non-US) developed markets and emerging markets, which could potentially enhance your returns over the next decade

The S&P 500 is just off a remarkable ten-year run, outperforming cash by an annualized 11.9%. That’s an exceptional outcome that lies well above the 90th percentile of rolling ten-year returns across global developed market stocks since 1950.

Repeating that kind of performance would mean nailing some long-shot wins: both extraordinary real earnings growth and all-time-high valuations. And while that might not be impossible, it’s an implausible baseline assumption.

With that backdrop, you may want to consider reducing your exposure to the US and shifting toward more attractively valued regions, like (non-US) developed markets and emerging markets, which could potentially enhance your returns over the next decade

Mentioned in story

A good, strong run can turn a lot of heads. Thing is, they tend not to carry on forever. And that’s true even for US stocks. Sure, the S&P 500 recently ended a remarkable ten years. But some fairly simple math – courtesy of AQR Capital Management – shows that however roaring the next decade turns out to be, a repeat of that performance would require unprecedented expansions in earnings and valuations. Let me explain why and what it means for your portfolio.

Just how good was that run?

In the ten years leading up to June 30, 2023, the S&P 500 saw an average annual return of 11.9% above what might’ve been earned in a simple cash account, outshining everything from non-US developed-market shares to commodities. That’s an exceptional outcome – even for stocks – and stands well above the 90th percentile of rolling ten-year returns across global, developed market stocks since 1950.

US stocks outperformed all other major asset classes and quite a few hedge fund strategies over the past decade. Source: Bloomberg.
US stocks outperformed all other major asset classes and quite a few hedge fund strategies over the past decade. Source: Bloomberg.

What drove it?

To answer this, AQR decomposes the whole thing into a handy equation. First, it breaks down the excess-of-cash return on the stock market into the difference in two components: the real (inflation-adjusted) return on the market minus the real return on cash. Second, it breaks down the real stock market return into three sources: dividend yield, growth rate of real earnings per share (“real earnings growth”), and capital gains or losses associated with the price-to-earnings ratio becoming richer or cheaper (“multiple expansion/ contraction”). Here’s what that looks like mathematically:

Excess of cash return = (Dividend yield + Real earnings growth + Multiple expansion) – Real cash return

Using this breakdown, you can see that the 11.9% average annual excess return over the past ten years was achieved via an annual 3.6% growth in the multiple, average real earnings growth of 4.5%, and a dividend yield of 2.1%. Cash would actually have lost you 1.7% a year in real terms over the period (thanks to the decade’s mostly exceptionally low interest rates), so that further boosted stocks’ excess return.

The decomposition of US stocks’ historical returns. Source: AQR.
The decomposition of US stocks’ historical returns. Source: AQR.

The chart also shows just how exceptional the S&P 500’s 11.9% outperformance over cash was. Since 1950, the average excess return has been just 7.1%, with both multiple expansion and real earnings growth increasing at a slower rate. On the other hand, holding cash during that historical period would have yielded a positive real return – which, if you think about it, is part of the reason why stocks had a lower outperformance. (They just couldn’t compete as easily with cash.) Finally, dividend yields were a much bigger contributor in the past than they’ve been since 2013.

Can we expect a repeat performance from stocks?

AQR attempts to answer this through a thought experiment using the breakdown above – hoping it will force investors to reconsider their expectations. Here’s their thinking.

First, don’t assume much change from dividends, which tend to hold pretty steady. Companies, after all, want to avoid the negative signal that comes with shrinking their payouts, and tend to be ultra cautious about raising them. So the S&P 500’s current dividend yield of 1.5% is a good estimate for this component of returns. Second, cash is quite unlikely to do as badly as it did in the aftermath of the global financial crisis and later during the pandemic crisis. Those calamities kept interest rates exceptionally low for most of the past decade. The Federal Reserve’s (the Fed’s) median estimate of the equilibrium real funds rate (often called the neutral rate or “r-star”) is 0.5%, which we can use as a best guess of real cash returns over the next decade.

So, if real cash returns an average of 0.5% per year (remember: that’s adjusted for inflation), then hitting an 11.9% excess-of-cash return would require a real stock market total return of 12.4%. Subtracting the 1.5% dividend yield, then, would leave 10.9% to be explained by a combination of real earnings growth and multiple expansion.

Mind you, this begs a couple of important questions:

1. Can valuations expand?

After a decade-long expansion, valuations are already very stretched – and that could be an issue here. To see this more clearly, consider the Shiller cyclically adjusted price-to-earnings (CAPE) ratio, which is (by far) the most useful valuation measure when analyzing stocks over long periods. The CAPE gets rid of cyclicality by comparing prices to average earnings over the previous ten years, adjusted for inflation.

Today, the S&P 500’s CAPE is 32x – one of its highest readings on record. It was just 24x a decade ago. And, sure, several factors could explain the natural increase in the CAPE over time, including shifts in tax regimes and rising profitability. And it does trend higher when interest rates are lower. But it’s still very hard to justify where the CAPE sits today – even higher than on the eve of the Great Crash of 1929. In fact, the CAPE’s been higher only twice: for about a year during the dot-com bubble and for a few months during the speculative waves that followed the pandemic.

History suggests that stock valuations won’t get richer over the next ten years. Source: Bloomberg.
History suggests that stock valuations won’t get richer over the next ten years. Source: Bloomberg.

So those already-lofty levels are one reason why valuations might struggle to expand further, but here’s another: the end of near-zero interest rates. Borrowing costs in the US are at a 22-year high of 5.4% right now. And the Fed’s own projections show rates declining only gradually – to around 2.9% by the end of 2026.

That may give you an idea of what to expect from stocks. See, higher CAPEs have long been associated with lower subsequent ten-year stock returns (and vice versa). So the raw level of the CAPE suggests we shouldn’t expect too much of the next decade. That is, unless…

2. Can real earnings growth pick up the slack?

From 1950 to 2023, real earnings growth averaged 2.6% a year – a bit less than the US economy’s 3% growth rate. (At the 75th percentile, real earnings growth expanded at 4.1%, and at the 90th, at 6%) Over the past decade, however, real earnings grew by around 4.5% per year. That’s a pretty outsized level, relative to history, and, from a statistical standpoint, is unlikely to repeat. Things like earnings growth typically exhibit what’s called “mean reversion” – with strong recent growth tending to be followed by weak future growth, and vice versa.

To be sure, the past isn’t necessarily a perfect predictor. New things have happened and are likely to continue to happen. For example, if AI really delivers a big step change in productivity and profitability (as many predict), earnings growth could improve. On the flip side, the recent resurgence in union bargaining power could put a squeeze on profits. And, if interest rates are considerably higher over the next ten years (like we talked about), that could also squeeze profits, by driving up borrowing costs.

Couldn’t the CAPE keep rising, enough to maintain those excess returns?

AQR attempted to answer that question, figuring out what kind of CAPE level would be required a decade from now, under various real earnings growth scenarios, to replicate the past decade’s 11.9% excess return. This chart stands out as the most significant (and revealing) from the investing house’s research paper:

CAPE level required in ten years to achieve an 11.9% excess return (under various real earnings growth assumptions). Source: AQR.
CAPE level required in ten years to achieve an 11.9% excess return (under various real earnings growth assumptions). Source: AQR.

Even if real earnings growth averages a whopping 8% over the next ten years (a massive jump from the 4.5% we’ve just seen), the CAPE would still need to go back to its record high of 44x, set during the peak of the dot-com bubble, for US stocks to replicate the past decade’s 11.9% excess return. Any less ambitious earnings growth assumptions would require a CAPE well above its all-time record. It’s impossible to rule this scenario out, but it’s fair to call it implausible.

So with the odds stacked against US stocks, where’s the opportunity?

Well, if you look at stocks from other countries, the math changes, since their valuations are nowhere near as extreme. And, to be fair, it can be misleading to directly compare CAPEs of different markets – some are pricier than others for valid reasons. (Big Tech, for example, works to maintain an above-average CAPE in the US.) But if you compare a market’s CAPE to its own historical average, it can give you a good rule of thumb for spotting those that look expensive or cheap. And you can use this website from Barclays to chart historical CAPEs by country. But to more easily visualize where a country’s CAPE lies relative to its historical average, I recommend this great online tool from Research Affiliates (you might need to register for full chart access – it’s free).

From there, you’ll see that in addition to the US, stock markets in India and the Netherlands are particularly expensive. On the other hand, Germany, Japan, Brazil, China, Indonesia, Malaysia, Mexico, Poland, South Africa, Thailand, and Turkey all look cheap. Most of those are emerging markets (EMs), and it’s true that EM stocks as a whole are attractively priced: their current CAPE, at 14.1x, falls in the 31st percentile, on a historical basis. But even developed markets (DMs) look reasonable, once you remove the US: that group’s current CAPE, at 17.9x, is in the 37th percentile.

Country by country, these are the historical CAPE levels (shaded squares, which show the midspread, or interquartile range), along with their current levels (small circle). Source: Research Affiliates.
Country by country, these are the historical CAPE levels (shaded squares, which show the midspread, or interquartile range), along with their current levels (small circle). Source: Research Affiliates.

So it makes sense to consider shrinking your allocation to US stocks and increasing your exposure to more attractively valued regions, potentially enhancing your returns over the next decade. The Vanguard Total International Stock ETF (ticker: VXUS; expense ratio: 0.07%) and the iShares MSCI Emerging Markets ETF (EEM; 0.69%) could potentially get you started.

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