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Many investors are still bewildered that the shock of 2020’s economy gave rise to the awe that is this year’s stock market. The puzzle gets worse: Stocks have done better than their norm of the past century even if you invested at the high in 2007 and held through both the worst financial crisis and worst pandemic in 100 years. What on Earth is going on?
The answer should give pause to investors who plan to hold for the long run. Stocks have won big, not primarily because earnings went up but because the cost of money went down almost to zero. A repeat in the next decade is almost inconceivable, which means future returns are likely to be pedestrian, at best.
To put some numbers on it, an investor who bought the S&P 500 in October 2007, stayed calm as Lehman Brothers went bust, and ignored the repeated panics and the pandemic made an annualized 7.3% above inflation, including dividends. That is far better than the 6.5% annualized real return on U.S. stocks from 1900 to the start of this year calculated by academics Elroy Dimson, Paul Marsh and Mike Staunton for Credit Suisse. It is on a par with the postwar returns of 7.4% over inflation annually from 1950 to the start of the year, despite the great financial crisis and the pandemic, the worst hits to the economy since the second world war.
This year is a fine example of why: In 2020, falling earnings coincided with much higher valuations of future earnings, as lower interest rates and bond yields made stocks look more attractive.
Unpack that thought and the implication is that we are paying more for the same future stream of income. That is, stocks offer pretty much the same prospective profits and dividends that they did before, but at a higher price. Sure, some biotechnology and videoconferencing stocks have had their growth accelerated by the pandemic, but shareholders of airlines, shopping-mall owners and travel companies will be using a big chunk of future profits to pay for the debt needed to survive 2020. The market assumption is that 2020 is a write-off but that S&P earnings in 2021 will be about 4% above last year’s, and 2022’s will reach roughly where 2021’s were expected to be before the pandemic hit.
The reason to pay more for the same is the hunt for yield, or TINA, There Is No Alternative (to stocks). The 10-year Treasury offers less than 1%, making stocks look attractive—so the price goes up. But paying more for the same earnings means lower future returns, unless bond yields repeat the trick.
And here is the problem: Treasury yields can’t keep falling indefinitely. This year alone the 10-year has fallen from 1.9% to 0.9%. Repeat the drop and yields would be negative. The Federal Reserve insists it won’t take interest rates negative. Even if it did, there is a limit to how low it can go, with even the fans of negative rates at the European Central Bank thinking banks would start to have serious problems below minus 1%.
None of this means that stocks are overpriced. To see this, compare with 2000, the last time stocks were incredibly expensive—a little more expensive than they are now, at least on forward price-to-earnings multiples and Prof. Robert Shiller’s cyclically adjusted price-to-earnings ratio.
Back in 2000, stocks were very unattractive compared to bonds. The 10-year Treasury yielded more than 6%, while the U.S. market’s dividend yield reached an all-time low of just above 1%. The most generous measure of how much shareholders are making, the earnings yield that includes not just profits paid out but also profits reinvested, fell below 4%. Investors were betting big that unprofitable companies, many without any revenue, would be huge successes in the future. Few lived up to the hype ( Amazon did, eventually).
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Since the dot-com bubble high in March 2000, stocks have had a poor return compared to history—just 4.9% annualized after inflation. By the 2007 peak, they had risen only 16% in total, less than inflation. And that was with the tailwind of a huge drop in bond yields. All of that poor performance was because of valuations falling as the bubble burst, with the forward P/E down by a third from 2000 to 2007, even as forecast earnings rose 68%, more than in the past 13 years.
This is both the good and the bad news. If earnings keep growing as they have in the past, stocks might offer annual gains around 3% to 4% above inflation, averaged over many years. That should be regarded as an absolute triumph at a time when Treasury inflation-protected securities offer a guaranteed return of 1 percentage point below inflation for 10 years.
Unfortunately, 3% to 4% plus inflation wouldn’t be the sort of return to excite the Robinhood trader, or enough to satisfy the needs of America’s underfunded pension schemes, even if nothing goes wrong.
It might seem odd that if the future avoids the twin disasters of financial crisis and pandemic that stocks should be expected to offer less than in the past 13 years. But that is because valuations, or what is already priced in, matter so much—and thanks to the Fed, many good years are already anticipated.