Three trends support the case for a greater focus on carry in a portfolio:
Lower equity returns
The BlackRock Investment Institute forecasts just 4.3 percent annual returns for domestic large-cap stocks over the next five years, mostly due to elevated valuations. Today the S&P 500 trades at roughly 19 times trailing earnings. Small cap valuations are even more elevated, with the Russell 2000 trading at over 35 times trailing earnings. In our opinion, this bodes poorly for future long-term returns. Other markets, notably emerging markets (or EMs), are likely to perform better thanks to much lower valuations. However, EMs come with considerably more risk, a problem for more conservative investors.
Market Realist – Valuations matter for future returns.
The graph above compares the trailing 12-month price-to-earnings ratio of the S&P 500 index (VOO) (IVV) with emerging markets. It’s tracked by the MSCI Emerging Market Index (EEM) and developed markets ex-US and Canada. That’s tracked by the MSCI EAFE Index (EFA). The graph also compares their ten-year averages.
The S&P 500 is trading at 19.1x earnings, which is a 14% premium over its ten-year average. Emerging markets are trading around their long-term average of ~13.5x earnings. Developed markets also seem expensive, trading at 22.5x earnings, which represents a 9% premium over the ten-year average.
With commodity (DBC) prices seemingly bottoming out, at least for now, emerging markets appear more attractive than developed markets.
The S&P 500 has seen multiple expansions since March 2009 when it was trading at 11.1x earnings. The index has seen seven years of multiple expansion backed by accommodative monetary policies.
While stocks don’t seem to be in a bubble, multiple expansion is a factor for future returns. Historically, stocks have done slightly worse in years following multiple expansion. Since 1954, the return, net of dividends, on the S&P 500 Index has averaged 5.9% following the years in which stocks got more expensive, according to BlackRock. On the other hand, the average return after multiple contraction was above 10%.