What can we expect from equities in the near future?

Some commentators, pointing to the price to earnings (P/E) ratio for major indices like the S&P500, argue the next decade will be terrible for equities. Are they right? There are always plenty of people happy to offer their opinion.

The question itself is perhaps not right because most serious equity investors tend toward investing in companies, not the index.

Nevertheless, and remembering the lower the price you pay, the higher your return, it helps to have a framework for thinking about market value. What return might the market, or investing in shares generally, offer an investor commencing today?

Before answering that question, let me summarise how we arrived at this point with respect to the stock market and interest rates.

Amid the Global Financial Crisis, the U.S. Federal Reserve slashed the fed funds rate to zero in what is now viewed as an unprecedented step to shield the economy from its aftermath. Despite fears, this bold decision did not escalate inflation beyond its sub-two per cent mark. It enabled the Fed to sustain lenient monetary policies, including low interest rates and quantitative easing, for nearly 13 consecutive years. This period ushered in a record-breaking economic revival spanning more than a decade.

Profitless prosperity companies and rising inflation

Businesses, even those operating at a loss (I call them ‘Profitless Prosperity’ companies), effortlessly acquired loans, evaded default, and went public. Meanwhile, asset owners thrived with the present value of future cash flows freed from the gravitational pull of higher interest rates. Early gains prompted complacency, and widespread fear of missing out followed, fuelling stupendous rises in the market values of everything from shares and property to art, collectible cars, cryptocurrencies, and non-fungible tokens (NFTs). However, the subsequent and vast COVID-19 relief initiatives, and associated supply chain disturbances, set the stage for rising inflation by creating a surfeit of money for limited goods.

As inflation surged in 2021 and continued into 2022, the Fed was compelled to terminate its lenient approach, resulting in a swift hike in interest rates.

Irrespective of whether you subscribe to the idea of further hikes in interest rates to contain persistent inflation, the equally compelling idea that rates will need to be cut amid an inevitable recession, or my own view that rates stay about here for an indeterminate amount of time, you must agree a return to zero rates is unlikely. And that has ramifications for your return expectations.

Given the next decade will render zero rates a fond but distant memory, a recalibration of expected returns seems appropriate. Investors may also need to consider hurdles confronting corporate profitability, asset value growth, borrowing, and heightened risk of defaults, the latter especially among companies I have long described as being from the ‘Profitless Prosperity’ camp.

While I believe the investment climate is unlikely to be one that fuels stupendous equity market gains, I don’t believe the dire prognostications either. Nevertheless, relying solely on post-2009 investment tactics such as momentum won’t yield the desired outcomes in forthcoming years either.

A look at history – companies gain, but markets go no where

In November 1999 – just a few months before the DotCom crash, Warren Buffett presented at the Allen & Company Sun Valley conference, to a bunch of tech entrepreneurs and their backers, Bill Gates, and a phalanx of old-world media moguls, billionaires and Hollywood producers.

Warren Buffett’s first slide revealed just two Dow Jones Industrial Average values. The first was for December 31, 1964: 874.13 points. The second was for December 31, 1981: 875.00 points.

Buffett noted that during the 17 years highlighted, the size of the U.S. economy grew fivefold, as did the sales of the Fortune 500 companies. Yet despite these gains, the stock market went nowhere.

I would note that during this period, U.S. ten-year treasury bonds rose from circa 4.20 per cent to almost 14 per cent.

At the 1999 Sun Valley confab, Buffett contrasted that 1964-1981 period to the 1990s “baloney” bull market (the Dow Jones index was at 11,000 and had risen an average 13 per cent per year for the prior 18 years).  Profits had grown much less than in the previous period, yet stocks were expensive because interest rates were low.

In fact, U.S. ten-year Treasury bond rates had sunk from 13.89 per cent to 6.54 per cent.

Discussing interest rates, Buffett noted, “What you’re doing when you invest is deferring consumption and laying money out now to get more money back at a later time. And there are really only two questions. One is how much you’re going to get back, and the other is when.

“Now, Aesop was not much of a finance major, because he said something like, ‘A bird in the hand is worth two in the bush.’ But he doesn’t say when. Interest rates – the cost of borrowing – are the price of ‘when’.  They are to finance as gravity is to physics. As interest rates vary, the value of all financial assets – houses, stocks, bonds – changes, as if the price of birds had fluctuated. And that’s why sometimes a bird in the hand is better than two birds in the bush and sometimes two in the bush are better than one in the hand.”

Referring to the 1990s bull market, Buffett noted birds in the bush were expensive because interest rates were low. In other words, nobody wanted the bird in the hand (cash), so they had gradually migrated towards more attractive relative returns.

For 39 years since 1981, declining interest rates fuelled a seemingly interminable rise in assets irrespective of whether they generated cash or profits. The gravitational force on asset prices was light, so asset prices rose. Today, however, bond rates are signalling a different mindset is necessary.

U.S. Ten-year Treasury bonds

U.S. Ten-year Treasury bonds, by way of example, have risen from a low of 0.50 per cent in August of 2020 to 4.56 per cent today. In Australia, ten-year bonds have similarly risen from an August 20202 low of 0.71 per cent to 4.37 per cent today.

Some commentators, particularly those who may have a vested interest in businesses outside of equities, have pointed to the fact higher interest rates are the death knell for share markets, and that they are set for a terrible decade. Some also note Buffett’s 1964 to 1981 episode where the market produced no return for index investors.

Will P/E ratios recover?

It may be true that returns could be lower in the next decade, particularly if P/E ratios don’t recover from the depressed levels they recently hit. But it is not the case that anyone expects rates to rise to the 15 per cent seen in 1981 either. Indeed, it is my view we see rates do absolutely nothing for a long time. And if that happens, the initial ‘sticker shock’ of rising rates will abate, and consumers and investors will go back to being ‘at ease’.

And let me remind you of a mathematically immutable law of investing:  Buy and sell the same stock on the same P/E ratio, and your return will equal the earnings per share (EPS) growth rate the underlying business achieves. If you buy a stock on a P/E of 12 and sell it in a future year on the same P/E ratio of 12, and if, in the interim, the underlying business’s earnings per share (EPS) grows annually at 15 per cent, you will make a 15 per cent return per annum. Buy and sell the stock on a P/E of 10, or 20 or 25, and your annual return will still equal the EPS growth rate.

The only thing that can upset that apple cart is buying the stock on a higher P/E ratio than when you sell it. For the P/E ratio to decline however, the popularity of the stock market needs to be lower at the time of sale than at the time of purchase. This compels you to buy stocks in high-quality growing businesses when they are unpopular. In other words, when the P/E ratio is relatively low.

Pointing the Robert Shiller’s CAPE ratio (Cyclically Adjusted PE Ratio), some commentators have noted the S&P500 is on a cyclically adjusted P/E ratio of 31 times and that historically, returns have been very low for the index over the subsequent decade when the P/E is above 30. By way of comparison the standard P/E ratio for the S&P500 index is 18.2 times.

But remember we aren’t buying the index. We are buying individual companies. And it is not the case that all company shares are trading on a P/E of 31. The S&P500, whose P/E is described as being historically expensive, is being led by just seven mega-cap technology companies that are dragging the P/E of the overall index much higher than it would be if they were excluded. That means 493 other companies in the index might have meaningfully less exuberant P/E ratios. Secondly, plenty of innovative and growing companies do indeed have much lower P/E ratios, reflecting nothing but a lack of popularity.

By way of example, the S&P600 small cap index is on the same P/E ratio (12.3 times) we have only seen during recessions and crises in the last quarter century. The only time the P/E ratio for the S&P600 small cap index has been lower is at the end of 2022, during the COVID sell-off, and during the Global Financial Crisis. Plenty of innovative and growing companies appear to be on their knees in terms of popularity.

Another way of determining whether or not the market is expensive is by comparing the stock market’s earnings yield to the yield available on bonds, after adjusting for the risk of being in equities.

U.S. 10-year bonds currently yield 4.56 per cent. The equity market risk premium is estimated at about 3.5 per cent. Adding these two together, we arrive at an implied ‘fair value’ earnings yield of 8.06 per cent. The earnings yield is the inverse of the P/E ratio, so by dividing 8.06 per cent into 100 we arrive at an estimated ‘fair value’ P/E of 12.4 times earnings. And guess what, the U.S. S&P600 Small Cap index P/E is 12.3 times.

Now, you could argue that small caps require a higher equity market risk premium, and I think that’s a fair argument. But that would merely render the index only slightly expensive.

It’s also the case that we aren’t investing in the index at all but individual companies and provided we stick to higher quality companies that are able to grow earnings at double-digit rates for some years, you should do just fine.


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