A Cautious Look into the Future

Last year was a good year for investors. The S&P 500 rose 24.2%, or 26.2% with dividends reinvested. It defied some gloomy expectations entering the year after a more difficult 2022. That year, however, contained a lesson for the perpetual forecasters of ever-higher stock prices. What has been referred to as the “everything bubble” peaked with the ebullience of 2021, when speculative assets from cryptocurrencies to the stocks of dubious ventures ascended skyward and then began their descent. Last year was a reprieve for some of them. But our intent here is to consider paths forward for equities with history as navigation.

The first chart shows the performance of the two principal equity indexes. However good the performance of the S&P 500, the NASDAQ was materially better:

The NASDAQ’s performance was driven by a narrow group of competitively advantaged firms, known as the “Magnificent Seven”. We will return to that subject later after considering the broad market in historical context.

The last three years for bonds have been quite different. After a 40-year bull market that reached its climax in the chaos of the pandemic year 2020, bonds were not the place to be. From early 2021 to the end of 2023 long Treasuries declined in price and produced an annualized total return of (12.0) %. (Note 1) This is significant because of the scale of the divergence from stocks, and particularly because Treasuries are the risk-free basis for pricing all other (U.S.) assets.

Some decades ago Prof. Robert Shiller developed a way of looking at the relationship between stocks and bonds. He proposed the Cyclically Adjusted Price/Earnings Ratio, or “CAPE”, which averages the most recent ten years of monthly observations. The last several decades appear in the next chart.

This way of looking at equity valuations allows us a simple way of comparing them to bond yields. The CAPE is converted to an earnings yield, which is the reciprocal of the CAPE ratio. The bond yield is subtracted to produce an “Excess CAPE Yield”. This is the extra expected return (most of the time) from stocks over default-free bonds.

Stocks became relatively expensive in the early 1970s as the growth stocks of the day (the “Nifty Fifty” as they were known) ascended until they stopped, followed by the grim 1970s when equities in general were devalued in response to the inflation of the time. Bonds were affected also, but it was equities that did the worst. As inflation receded over the next couple of decades both asset classes did much better, which eventually blossomed into the Dot-com boom of the 1990s. That was the all-time low for the Excess CAPE Yield, which then rose in response to the Global Financial Crisis of 2008-09. Most recently the relatively sharp rise in bond yields combined with the strength in the stock market has eroded part of the relative attraction of stocks. The history appears in Chart 3.

Shiller’s data goes back to the late 19^th century (starting in 1871, to be exact). While such diligence is praiseworthy, we have taken the data subset that begins in 1960. This excludes the Great Depression and WWII (and its related price controls) to construct a data set that has a reasonable probability of being more comparable to the period we are trying to anticipate—the early 21^st century. In any event, whether we use CAPE or its excess yield over bonds, stocks in general are below their highest levels, but at the 90^th percentile or so leave less room for error.

The question, then, is quantifying what this means for returns going forward. Shiller also publishes calculations of the annualized (i.e., per year) returns over the next 10 years from any given year in the data set. From that data we can calculate the relationship between either independent variable, the Excess Yield or the CAPE itself, and return over the following decade. The results appear as Charts 4 and 5.

The line on the charts show the central tendency of each of the relationships, and the numbers are the regression equations that allow us to quantify what we are entitled to expect from the most recent observations. The results appear in Table 1:

Both methods produce discouraging results. It is true that they may be excessively so. The market’s 2023 results were driven in no small part by the exceptional performance of the “Magnificent Seven”—Amazon, Apple, Google, Meta, Microsoft, Nvidia and Tesla. In our observation, their competitive positions are among the strongest we have seen of any market leaders in the past. Whether they can carry the entire market for years to come is questionable, however, particularly considering the valuation expectations at which they already trade:

However excellent their positions appear today, competitive advantage can be difficult to sustain. Coca-Cola, among others for example, was a member of the “Nifty Fifty” of the early 1970s, and can claim that they have sustained competitive advantage, in no small part because of their global distribution structure. Then again, Polaroid, Burroughs and Simplicity Pattern were part of the same group. Enough said.

In making investment decisions it is wise to be mindful of the longstanding principle of a margin for error. Forecasting is hard, especially of the future, as it has been said. Our view presented here may be conservative; indeed, we hope that it is. But proceeding on such a basis is likely to avoid large mistakes, which is a head start on growing capital over time.

Note 1. Bloomberg, data for TLT ETF.