Temper your indexing expectations.

No, an 8% long-term (real) return on the S&P is not realistic.

I’ve found myself having a few conversations recently about long-term investing returns, and I’ve become increasingly convinced that most (US) investors’ expectations for their long-term return investing in stocks is completely unrealistic.

Expectations

If you ask a large group of American index investors what they expect the S&P 500 to return over the next 30 or 40 years, I suspect most people would answer around 10%. Indeed, if you use the Moneychimp DCF calculator, the default value it gives for “return available on an appropriate market benchmark investment (like the S&P 500)” is 11% (to be fair, this is the discount rate the calculator uses, and I appreciate that the high rate encourages conservatism). Though people rarely specify it alongside their return expectations, most of those people will give that estimate under an expectation of 2% inflation - though 3% has also become a popular number more recently.

Those expectations imply an annual real return of 7-8%.

Before I talk about whether that’s realistic, it’s worth discussing where these expectations probably come from. In my view, there are two factors at play here.

• The first is that the last 15 years have been possibly the greatest bull market in modern history. In February 2009, the S&P 500 averaged 735. Today, it sits at around 5700 - a 14% CAGR; or if you include dividends, almost 16%. Over the same period, the inflation rate has averaged only 2.6% (and if you exclude post-pandemic inflation, as many people mentally do, under 2%).

• The second is that the long-term nominal return (with dividends reinvested) has also been strong - almost 11% since 1970.

So investors conclude 10% is a reasonable, maybe even conservative, nominal expectation.

Is 10% a year realistic?

What people miss, though, is that this long-term return did not occur under the ~2% inflation conditions that we have come to expect. Inflation over the same period averaged 4.0% and peaked at almost 15% in March 1980. That puts the real return at 7% since 1970.

The other crucial factor, of course, is the level of valuations. The price-earnings multiple at the start of this period was 15.8; today it’s about 30.

That expansion alone accounts for 1.2% a year. I think all sensible investors would agree we should not plan for any long-term multiple expansion from our current (fairly anomalous) level - so we can cut our expectation down to 5.8%. And in fact, I think most sensible investors would agree we should expect some level of mean reversion - a fall to 20x (still on the higher end of the historical average) over the next 30 years would bring our real return down to 4.5%.

To me, that feels like a pretty reasonable, conservative expectation. You’ll still double your purchasing power every ~16 years.

But I would not call it pessimistic - we can go a lot further.

1. High valuations aren’t only bad insofar as they may come down - they also mean that (for an equivalent payout ratio) dividend yields are lower, and dividends are a major component of the return since 1970.

2. The decades since 1980, excluding the past couple of years, have been characterised by falling or ultra-low interest rates. That downwards trend cannot continue over the next three.

3. Corporate tax rates have fallen significantly, from almost 50% in 1970, to just 21% today. Again, that is not likely to continue, and indeed seems likely to reverse at some point.

4. Technological improvements since 1970 have been absolutely immense, and the effect that’s had on worker productivity is hard to overstate. If AI does not turn out to be the massive boon to productivity that the markets are hoping, this tailwind is likely to weaken.

5. Globalisation has been a massive tailwind - both for the consumer, who has benefited from a flood of cheap imported goods (think about what the last 40 years of inflation might have been like without East Asian imports); and for the corporation, who has both expanded profit margins by moving supply chains east, and found an enormous supply of new customers. Consensus is that globalisation will now begin to retreat, reversing yet another tailwind.

6. The US debt burden has exploded. 2023’s fiscal deficit was 6.2% of GDP, and spending was almost 1.4x revenues. That is clearly not sustainable.

Where does this leave us?

Despite how I may have just come across, I’m not really a bear. I think investing in the stock market will almost certainly continue to be a pretty good idea over the long run. But let’s not stick our heads in the sand either - this does leave us in an interesting position. Prices in the US market reflect the optimistic assumptions about future returns detailed at the start, and (assuming I’m directionally correct), investors are in for a nasty surprise when those assumptions are challenged. US investors will at some point have to face the reality that not only prices, but also earnings, can go down as well as up. A combination of multiple compression and denominator compression could be… rough.

Are bonds the answer?

In Howard Marks’ Dec ‘22 memo Sea Change and its Oct ‘23 follow-up, he makes the case that rising interest rates and present high equity valuations constitute a fundamental shift in the investment landscape - a ‘sea change’ - that calls for a corresponding shift in investment strategy. In particular, he suggests that “credit instruments should probably represent a substantial portion of portfolios . . . perhaps the majority.” Marks cites the ICE BofA U.S. High Yield Constrained Index - which at the time was yielding about 8.5% - and suggests this offers equity-like yields with much less uncertainty.

Unfortunately, long-term treasury yields are down about 1% since then, and credit spreads have compressed - that high-yield index is now yielding only 6.65%. Not terrible, but not fantastic for non-investment grade.

Is active management the answer?

A sentiment I’ve heard from several investors, most notably Stephen Clapham of the Behind the Balance Sheet podcast, is that the last decade has been the decade of passive investing, and the next will be the decade of active management.

If you believe, as I do, that prices of stocks are still set principally by active managers (at least relative to one another - indexed inflows probably still have the effect of a rising tide which (proportionally) lifts all boats), it’s hard to see exactly how this would work. In essence, when you invest in a passive market cap-weighted fund, you’re just aggregating the recommendations of all these active managers. Put another way, if passive owns 70% of every sector’s float (that is, the shares not held by insiders or major private shareholders), industry active necessarily owns the remaining 30%.

Granted, there are sector-specific passive flows, which would then replace the active management holding in those sectors as they drive the price up; and perhaps, if passive money moves from trend to trend, buying active investors out at attractive (selling) prices, while allowing the active investors to buy whatever un-trendy areas passive is moving out of attractive (buying) prices, then active could conceivably outperform; but I suspect these sector-specific flows are minor, and it’s debatable whether they can even be called passive. Plus, this outperformance would rely on fund managers being capable of independent thinking (I’m remembering the joke about the oil prospector at the pearly gates).

A more important division is market cap. I can’t actually find any data on how the percentage of float held passively varies by size, but I would guess it’s significantly higher for the S&P 500 than the remainder of the US market. So possibly active will outperform by virtue of holding more small caps.

The final possibility is that active outperforms by holding more cash at certain times and timing the market well. But the historical record does not give a favourable outlook for that strategy. Altogether, I’d be very surprised if active equity strategies outperform after fees.

So what is the answer (for the casual investor)?

Well, unsurprisingly, I don’t have it. Sometimes there just aren’t that many good opportunities, and when this is the case, investors tend to chase yield, taking on excess risk when the reward for said risk (credit spreads or ERPs) is lowest.

My advice would therefore simply be to temper your expectations. Don’t plan for retirement based on an 8% real return, and do your best to ensure you are psychologically prepared for a significant (30%+) drop in your equity portfolio - you will probably see one at some point in your investing life.

Related to that suggestion, I will give a few slightly more concrete suggestions for casual investors.

1. Consider having some allocation to credit. Granted, the real returns on investment-grade bonds do not currently exceed the 4.5% I suggested as a US equity estimate - but (a) I don’t even have that much confidence we’ll achieve that figure, and (b) the present moment seems to me like a rare time when the optionality of having substantial liquidity to buy in should equities see a significant decline in prices exceeds the slightly lower long-term return expectation.

2. Diversify outside the US. I talked a little more about this in my write-up on Airtel Africa, but essentially I’m of the view that the massive multiple expansion in the US has convinced investors that the US offers returns so far superior that other markets needn’t even be considered; while simultaneously reducing the expected return (and increasing the risk) of US equities relative to other markets. The UK in particular is offering very undemanding multiples at the moment.

3. Buy Berkshire. They have a collection of fantastic (and importantly, unusually inflation-proof) businesses, and are trading at a much more reasonable price than most of the rest of the US market. Additionally, Berkshire is almost a natural hedge against a bear market, in that their long-term investment returns will improve markedly should one come along (probably not quite as well if Buffett is no longer around when it happens; but he’s had almost the entire investing world as the pool from which to choose his successors, and it would be surprising if they couldn’t also make some excellent investments).

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