You and your clients are probably delighted by the strong recovery from the bear market of 2022. With the increasing likelihood of a soft landing as inflation wanes and interest rates fall, and with Trump’s tax and deregulation policies a possibility, the short-term prospects for the U.S. stock market appear positive. However, what is more critical to investors, particularly those planning for or in retirement, are the prospects for long-term U.S. equities performance. For financial advisors, long-term expected returns for U.S. equities are a key input for strategic asset class allocations.
Unfortunately, judging by recent long-term U.S. equities return forecasts (in U.S. dollars) by major investment firms, there is more cause for concern than celebration.
The research group at Goldman Sachs & Co. LLC updated their long-term return forecast and estimates the S&P 500 will deliver an annual return of 3% over the next 10 years. Recognizing the uncertainty of any forecast, annual returns could be as high as 7% and as low as -1%, the group estimates. The most recent forecast for U.S. equities from Vanguard’s Investment Strategy Group is similarly lacklustre, ranging from 3.2% to 5.2% per annum.
Research Affiliates LLC provides two different forecast methodologies: one uses the current dividend yield and expected long-term growth, while the second considers whether the market is over- or undervalued relative to history. These result in estimates of 6.5% and 3.3% per annum for large-cap U.S. stocks. J.P. Morgan Asset Management and State Street Global Advisors are more optimistic, with forecast returns of 6.7% and 6.0%, respectively, for large-cap U.S. equities.
Our firm uses the average of expert forecasts based on the “wisdom of the crowd” logic. The average of the above is a 5.0% return annually. The contrast with the 15.4% annual return earned by the S&P 500 over the past decade is staggering. Although there are many reasons to believe U.S. economic exceptionalism will continue, the extraordinarily elevated value of the S&P 500 today is a blaring warning sign.
Such warning signs have been broadcast in the past. Over the past 100 years, there have been four U.S. market valuation peaks as measured by the cyclically adjusted price-to-earnings (CAPE) ratio.
The first occurred at the end of the Roaring ’20s, when the U.S. economy boomed after the First World War. CAPE peaked at 32.6 in September 1929, and the U.S. stock market went on to lose 3.0% a year over the subsequent decade.
The next peak occurred during the “Go-Go Years” of the 1960s, when CAPE reached 24.1 in January 1966. U.S. equities then earned 4.4% a year for the next decade.
The third peak occurred in December 1999 during the internet boom, when CAPE hit an unprecedented 44.1. Over the next ten years, the S&P 500 lost 1.0% a year.
The fourth peak occurred in November 2021 at a CAPE of 38.6. In fact, the selloff of pricey growth stocks in early 2022 as profit taking occurred likely contributed to the bear market.
With an estimated CAPE of 36.6 at the end of October this year, today’s valuation for the S&P 500 remains at an extremely lofty level.
Hence, advisors should be re-evaluating their allocations to the U.S. equities market with the following considerations in mind:
1. Don’t try to time the U.S. market. Studies on tactical market timing using valuation models have repeatedly shown this is a losing strategy. Expensive markets can get even more expensive as short-sighted investors chase “glamour” stocks and further drive up prices. Focus on your long-term strategic allocation of U.S. equities relative to more reasonably valued Canadian, international and emerging equities markets as well as real assets and private investments.
2. Diversify into segments of the U.S. stock market that offer more attractive values and potentially higher returns. Goldman Sachs research concluded that the S&P 500 Equal Weight Index is likely to outperform the cap-weighted S&P 500 Index over the next ten years by 2% to 8% annually due to its lower concentration of mega-cap stocks.
Large-cap U.S. value stocks (as measured by the Russell 1000 Value Index) are 27% cheaper today than large-cap U.S. growth stocks (as measured by the Russell 1000 Growth Index), based on their historic average valuation relationship since 1997. Small-cap value stocks are also trading near their 20-year average valuation level (based on price-earnings ratio) — a decided contrast to large-cap growth stocks, which are trading near a 50% premium. Trump’s “America first” economic policies could act as a tailwind for U.S. small-cap stocks.
3. Consider allocating across U.S. factors, such as momentum, quality and low volatility, using low-cost ETFs. Most forecasts expect modest return premiums to the overall U.S. stock market returns from exposure to these factors.
4. Allocate to active global equities managers. Global managers analyze companies around the world to identify and invest in attractive stocks with superior expected returns. In doing so, country allocations are primarily a byproduct of their fundamental stock analysis, although risk constraints may impose reasonable minimum allocations to major stock markets. Over 50% of the global equity mutual fund series and ETFs with gold or silver medallion ratings by Morningstar Direct currently underweight U.S. stocks in their allocations relative to these stocks’ global market capitalization weight. Interestingly, over 40% have overweighted their exposure to the Canadian stock market.
5. Recognize that a forecast is not destiny. Although extraordinarily high valuations and market concentration are real headwinds for high future returns, there is still possibility that the S&P 500 delivers high single-digit annual returns over the next ten years. Hence, avoid dramatic underweighting of this key equities market. Employing the previous recommendations provides a diversified approach that allows a meaningful weighting despite the headwinds to performance for the S&P 500.
Thoughtful strategic allocation is a core function of an advisor. This is a critical time to revisit your allocation to U.S. equities.
Michael Nairne, RFP, CFP, CFA, is president and CIO of Tacita Capital Inc., a private family office, and manager for TCI Premia Portfolio Solutions.