According to Research Affiliates (RAFI), the 10-year annualized real (inflation-adjusted) return for the S&P 500 is a measly 0.7% per annum. The chart below (as at September 30, 2014) shows that the long-term expected return for US equities is the lowest of the 30 markets researched by RAFI.
I created the chart using the Research Affiliates Expected Returns and Risk tool. The tool also has expected returns for fixed income, currencies and commodities. It is a very useful reference.
How did RAFI come up with 0.7% over 10 years? They use a fairly simple model that breaks down equity returns into 3 parts:
- Earnings growth
- Changes in valuation
Dividends are the primary driver of equity returns over the long term. If fact, if you hold equities long enough, most of your total return as an investor will come from dividends.
Of course dividends are not static. Over time, the dividends paid by companies will grow as their earnings grow. Together dividends and earnings growth help us to estimate the future cash flows generated by all of the companies in the market.
But what will investors pay for these cash flows in the future? This is where valuation plays its part. When investors are confident, they will pay more for a given set of future cash flows. Conversely, when investors are fearful, they will be pay a lot less. Valuation tends to even out over the long-term (in other words, it reverts to the mean), however it can dominate returns over the short-to-medium term.
Many institutional investors use similar models to forecast the expected return for equities. While not exact, they do work reasonably well over the long-term (7-10 years). For example, a similar model has been used by Jack Bogle of Vanguard since the early 1990s to create a reasonably accurate long-term forecast for US shares*.
RAFI use the following inputs to create a 10-year forecast for the S&P 500:
- The current weighted average dividend yield (dividend/price) of the S&P 500 = 1.8%
- Earnings growth estimate = 1.3%
- Expected change due to valuation = -2.4%
- TOTAL = 0.7%
The logic behind each of these inputs and the method used to calculate them can be found in RAFI’s Equity Methodology Overview.
To be clear, RAFI aren’t suggesting that the investment return of the S&P 500 for each year from 2014 through to 2024 will be exactly 0.7% real per annum. The truth is that nobody knows what each year’s investment return will be. Rather the 0.7% number equals the annualized real (inflation-adjusted) return forecast from October 2014 through to October 2024.
Let me repeat: the path to the forecast 0.7% annualized real return is impossible to predict. Their might be 7 positive years and 3 badly negative years. Or their might be 5 relatively flat years and 5 moderately negative years. We just don’t know; which is why this sort of analysis can’t be used for market timing.
But it can be used by long-term investors to reduce the risk of a loss of capital, or to profit from periods where the expected returns offered by the market are unusually high. It can also be used to set realistic expectations. For example, if US shares have an expected real return of 0.7% and US long-term treasuries also have a an expected real return of 0.7%, then how is the typical US 60% equities: 40% bonds balanced fund going to deliver a decent return above inflation? It can’t.
The 0.7% estimate will almost certainly be wrong. But the point of this exercise isn’t to figure out whether the 10-year real return for the S&P 500 will be 0.7% or 1.2% per annum. Rather, the point is to figure out the order of asset class returns. For example, will Australian shares out-perform US shares? Or will emerging market shares do better than European shares?
These models work on the principle that “you don’t need to know how much someone weighs to know if they are fat”.
Would an investor really want to invest in shares if the 10-year expected return after inflation was 0.7%? Would they be more likely to invest if it was 1.5%? How about if it was 2%? What about 3%? 3% might sound good, until they found out that the average annualized real return for US shares from 1963-2013 was 5.8%.
Whatever the 10-year annualized real return for US shares turns out to be, the probability is that it will be low, much lower than the historical average for US shares.
P.S. Here is a list of some of the references that I used in preparing this post.
Bogle, Jack. “1990s at the Halfway Mark”. The Journal of Portfolio Management,Summer 1995, Vol. 21, No. 4: pp. 21-31
Bogle, Jack. “Thinking About What Lies Ahead For Investors”, CFA Society of Washington, June 13, 2012
Credit Suisse Global Investment Returns Yearbook 2014