🤯 This Mind-Blowing Chart Reveals Why US Stocks Face A Tough Long-Term Outlook
The chart, taken from a fantastic research piece by AQR Capital Management, shows the cyclically adjusted price-to-earnings ratio (CAPE) needed a decade from now, under various earnings growth scenarios, for the S&P 500 to replicate its past 10-year performance.
For reference, the S&P 500 recently completed a remarkable 10-year run, outperforming cash by an annualized 11.9%. This is an exceptional outcome that lies well above the 90th percentile of rolling ten-year returns since 1950.
That strong run has brought the S&P 500’s CAPE to 32x today – among the higher readings on record, and even greater than on the eve of the Great Crash of 1929. Only for about a year during the dot-com bubble, and then for a few months during the speculative waves that followed the pandemic, has the CAPE been higher than it is now.
To replicate the S&P 500's performance over the next decade would require a heroic set of assumptions: valuations rising to unprecedented new highs and extraordinary real (i.e. inflation-adjusted) earnings growth.
For example, even if real earnings growth averages a whopping 8% over the next ten years (a big jump from the 4.5% we just had), the CAPE would still need to go back to its record high of 44x, set during the peak of the dot-com bubble, for the S&P 500 to replicate its past 10-year performance.
Any less ambitious earnings growth assumptions would require a CAPE well above its all-time record. While this outcome is not impossible, it is an implausible baseline assumption, suggesting that we need to recalibrate our expectations.
So with the odds stacked against US stocks, what should you do? Well, if you look at stocks from other countries, the math changes since their valuations are nowhere near as extreme.
Comparing a market’s CAPE to its own historical average gives a good rule of thumb for spotting those that look expensive or cheap. You can do that using this great online tool from Research Affiliates: https://lnkd.in/dwcQKqqE
From there, you’ll see that in addition to the US, stock markets in India and the Netherlands are particularly expensive.
On the other hand, emerging markets as a whole are attractively priced: their current CAPE, at 14.1x, historically falls in the 31st percentile. Even developed markets, once you remove the US, look reasonable: their current CAPE, at 17.9x, historically falls in the 37th percentile.
The key takeaway here is that it may be worth looking beyond the US borders when you’re hunting for stocks. Reducing your US stock holdings and shifting towards more attractively valued regions like developed markets (excluding the US) and emerging markets could potentially enhance your returns over the next decade.