Why the Next Decade May Bring Lower Returns—And What It Means for You (EP.176)

0:28We all need to make smart decisions with our money. term return forecast for U.S. equities that caused a bit of commotion in the financial world, or at least among the investing nerds like me. And if you've been following me for a while, you know full well that I'm not a believer in predicting the future. But I do think Goldman's research report has a few elements that make for an interesting conversation. So in this episode, we're going to talk about how one goes about forecasting future returns in the first place, the implications of potentially lower returns in U.S. markets over the next decade, and then throughout the episode, I'm going to share some considerations that ought to go into your portfolio construction.

1:08As always, you can find detailed show notes and links to additional resources at thelongterminvestor.com. So how does one forecast future returns? Well, for most people, it's roughly the same way that we explain past performance. And that's three things. It's changes in earnings per share, changes in cash paid to shareholders via dividends and buybacks, and lastly, changes in valuation. And you can dissect any past period of return and attribute those returns to these three factors. For example, the S &P 500 earned an annualized average total return of 13 % during the past decade. And roughly a fourth of that we can see came from dividends and just over half came from earnings with the remainder coming from expansion in valuation.

1:56Okay, so that's past returns. But in the case of Goldman Sachs and their report, they outline five variables in modeling their prospective long-term equity returns. And those five variables include starting absolute valuation, stock market concentration, economic contraction frequency, corporate profitability, and interest rates. And I'm naturally going to link to Goldman Sachs' piece in part because you might want to dig in more, but I really just think it's very readable even for the novice investor that's interested in learning more about some of these things. Now, the headline projection, though, that drew all the attention from people, at least in my corner of the world, is that Goldman Sachs estimates the nominal total return for the S &P 500 during the next 10 years to be just 3%, which would be 7th percentile returns when you go back to 1930.

2:48And that's noticeably different than the 13 % annualized total return the S &P 500 just posted that I just broke down by the various factors, and also much less than the long-term average of 11 % returns. Going beyond this headline, I think there's a number of things that are interesting in their commentary. For starters, Goldman suggests their forecast would be 4 percentage points higher if they excluded the impact of market concentration that, as they quote say, currently ranks near the highest level in 100 years. I actually explored the issue of market concentration in the S &P 500, in episode 146, aptly named, is the S &P 500 too concentrated?

3:32And I emphasized a similar point as Goldman's research, which is that it's extremely difficult for the largest companies to deliver outsized returns for a prolonged period of time. Reading directly from Goldman's research report, quote, Our historical analysis shows that it is extremely difficult for any firm to maintain high levels of sales growth and profit margins over a sustained period of time. The same issues plague a highly concentrated index. Furthermore, the risk embedded in high concentration markets is not always reflected in valuation. Now, there is a chart that I used in episode 146 that I will share again in the show notes at thelongterminvestor.com.

4:13And this chart comes from Dimensional, I think really drives the point home well. The short version being that not long after becoming one of the 10 largest companies by market cap, these stocks on average have lagged the market. And since you can't see the chart here as I'm talking, you can visit the longterminvestor.com. But from 1927 to 2023, the average annualized return for the stocks that are in the top 10 over those three years prior to joining the top 10 was more than 25 % higher than the market, which makes sense. That is how they became the biggest companies in the market. But five years after joining the top 10, these stocks were on average underperforming the market.

4:55Just five years later, they're underperforming by nearly a percentage point. And then when you go out 10 years further, they're underperforming the overall market on average by one and a half percent. Now, market concentration is not exactly a new phenomenon, and it's certainly no reason to panic. In fact, I saw a piece from Michael Mobison recently who made a really interesting case that market concentration is simply a common feature of a bull market. So with all that in mind, what should you be making of all this? I personally think the goal of navigating market concentration within the S &P 500 isn't just to try to avoid risk, but to understand it and manage it.

5:32Looking beyond the market cap weighted S &P 500 to other indices or diversification strategies naturally could mitigate some of these concentration risks. Within the U.S. alone, you can diversify beyond the S &P 500 to include mid-cap stocks, small-cap stocks, or even adding intentional factor weights, whether that's to value or momentum or profitability. Now, prudent investors should also have international market exposures to offset some of this concentration risk. Should we have this 10-year period where the S &P 500 has an average annualized total return of just 3 %? history has shown us that developed international markets have been an important source of return during those periods.

6:16In fact, when the S &P 500 has had returns below just 6%, international stocks have outperformed 94 % of the time. And when the S &P 500 has returns below 4%, that's when we've seen international stocks outperform each and every time throughout history. Now, speaking of diversification, another comment in Goldman's report that I found particularly interesting for conversation's sake, quote, our forecast suggests equities will face stiff competition from other assets during the next decade. Our 3 % annualized equity return forecast, combined with the current 10-year U.S. Treasury yield of 4%, and 10-year break-even inflation of 2.2 % suggests the S &P 500 has a roughly 72 % probability of trailing bonds and a 33 % likelihood of lagging inflation through 2034.

7:11End quote. Got to make sure you know we're done quoting. So really interesting, in my opinion, there's a slide in PlanCorp's quarterly market review. Again, link to that in the show notes at thelongterminvestor.com. and it has three periods that all share something in common. A 15-year period from 1929 to 1943, a 17-year period from 1966 to 1982, and most recently, a 12-year period from 2000 to 2012. These three periods are all decade-plus long periods in which the S &P 500 underperformed treasury bills. And a lot of people think of treasury bills basically as cash, So just think, and many of you have experienced this, but underperforming in cash is probably more psychologically taxing than underperforming bonds, but both would be really tough to live through.

8:02And that's exactly why I like this conversation, because it forces us to remember things that have happened before and quite honestly, I think are perfectly reasonable to expect will happen again in the future. Now, the one last thing I want to point out in Goldman's report is that a period of returns like they're predicting. If we were going to look at all rolling 10-year periods for the S &P 500, going back to 1935, only 9 % of the time were returns this low. And it's not really actually that low historical frequency that grabs my attention. I mean, those three decade plus periods I just referenced in which cash beat the S &P 500 makes me reasonably confident we will live through another such period at some point.

8:47But the thing about these low periods is that they usually have a very specific catalyst in which you can explain those subpar returns. So without a crisis of some kind, it's pretty difficult to envision such poor returns over the next 10 years. On the other hand, a crisis typically does come from something that nobody is thinking about. And I'm going to paraphrase Carl Richards, who says it so eloquently, risk is what's left over after you've thought of everything else. So let's wrap this up. what does this mean for you? For the true long-term investor, lower expected returns in the S &P 500 really doesn't mean anything.

9:29In my mind, a prudent investor should design their portfolio at the onset to account for unpredictable periods of good and bad performance. And long-term investors should expect downturns to occur with a similar magnitude and frequency as they have in the past, all while accepting that there really is just no way to predict them. Now, if you're sitting in a portfolio today that is dominated by U.S. large cap exposure, first of all, congratulations, because you've probably had fantastic performance over the past decade and really since the end of the great financial crisis. But I do think it may be time to think about diversifying your U.S.

10:10exposures, as well as bringing your international and emerging market exposures closer to a market waiting. As always, thanks for listening. And if you enjoyed this episode, please take a brief moment to rate and review the show on Apple or Spotify. Doing so helps people like you discover the show. So think of it as a way for you to help someone else make good decisions with their money. Until next time, to long-term investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com.

10:49Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.