Why To Expect Muted Returns from US Equities
We can expect muted returns from US equities going forward. US stocks face the prospect of higher interest rates, albeit gradual and from unusually low levels.
Nov. 20 2020, Updated 1:37 p.m. ET
To be sure, markets have staged big rallies from high valuations—stocks had a number of stellar rallies in the late 1990s when valuations were already high, for instance. However, valuations have mattered in the past, particularly when you look at time horizons of a year or longer. Looking at annual price returns over the past 60 years, annual price returns have been roughly 5 percent when the starting valuation on the S&P 500 was above the long-term median, roughly 16.5x trailing earnings. In contrast, according to the data, when the starting valuation was below the median, annual returns were generally in the low- to mid-teens. Investors should also take note that poor years—those in the bottom quartile of returns—tended to be worse when starting valuations were more elevated over the long-term average.
For investors, the main takeaway is that while US stocks are still likely to outperform US bonds, neither may provide particularly exciting returns over the next few years.
Market Realist – Expect muted returns from US equities going forward.
US stocks face the prospect of higher interest rates, albeit gradual and from unusually low levels. Let’s see how stocks perform, given high valuations and increasing interest rates.
In the three months following an initial rate hike, the S&P 500 has performed surprisingly better, if valuations have been increasing over the past year, as the graph above shows. This is probably because the momentum that led multiples to expand carries on despite tightening.
Over the longer horizon, however, multiple expansion coupled with tightening leads to negative returns. In comparison, we see double-digit returns when the market is characterized by multiple contraction in the years preceding tightening. In these scenarios, the S&P 500 has typically seen better returns in the six months and 12 months following tightening.
However, US equities look more attrative than bonds (LQD)(AGG), which are still yielding pretty low. Also consider international equities (ACWX), especially emerging Asian economies, for reasons mentioned earlier. European (IEV) and Japanese (EWJ) (HEWJ) stocks are likely to be supported by easy money over the next few months.
Read Why to Stay the Course in This New Age of Volatility for more on US stocks.