By: Dividend Sensei
Let’s start with this…
How 10.5% compound annual growth rate (CAGR) inflation-adjusted annual returns over the last decade are far above the market’s historical norm.
The market’s real returns are generally stable at 6.5%-7.5% CAGR over time, meaning about 8.5%-9.5% in nominal terms using long-term 2% inflation expectations.
The incredible bull market of the last decade is due mainly to multiple expansion. Stocks are now trading at their highest blended price-to-earnings (P/E) ratio in 20 years and their second-highest in history.
That bodes rather poorly for short- to medium-term returns.
In fact, analysts expect about 5.9% CAGR real returns from the S&P 500 over the next 30+ years. That’s 16% less than its historical annual post-inflation returns.
Fortunately, there is good and bad news for long-term stock investors, especially the kind that invest primarily in index funds.
According to JPMorgan Asset Management, there’s a 50% probability that the market’s future fair value blended P/E will be about 18.5, rather than the 17.3 mid-range we’ve seen over the last 10-20 years.
Ten- to 20-year timeframes are 90%-91% statistically significant. Assuming relatively similar economic, interest rate, and earnings growth fundamentals, the 10- to 20-year average multiple approximates intrinsic value.
The 17.2 average blended P/E of the last decade includes:
- Average 2.4% 10-year U.S. Treasury yields (blue-chip economists’ consensus average forecast for the 2020s is 2%-3%)
- More aggressive monetary policy from the Fed
- Aggressive corporate buybacks.
So why might the future fair value P/E for stocks rise to 18.5? Because, according to Ben Carlson of Ritholtz Wealth Management, the pandemic may have permanently reduced the risk of severe recessions.