Piling into U.S. stocks? Don’t Expect the Past Decade to Repeat

The head-turning performance of the S&P 500 Index has many investors clamouring for more exposure to these five hundred stocks. This widely-followed barometer of mostly-larger U.S. stocks has posted total returns in excess of 18% in six of the last eight calendar years. Five of those saw the index post 20+ percent returns. And with a relatively small group of very big and very profitable companies driving returns, it’s no surprise that investors are piling money into investment funds focused on shares of big U.S. companies.

Investors flocking to market segments that have done well in recent years is nothing new. The implied assumption is that these investors expect the good times to keep on rolling. An understanding of the sources of past returns may help put context around what is reasonable to expect from the U.S. stock market over the next several years.

Sources of Total Returns

The total return refers to changes in the price of a stock (or stock index) and the impact of reinvesting all dividends back into the stock (or stock index). Stock prices move in response to:

• changes in earnings (including the effects of inflation);
• how much investors are willing to pay for those earnings (the ratio of a stock or index’s price per share divided by its earnings per share – i.e., the P/E ratio); and
• the impact of reinvesting dividends.

The chart below illustrates my estimate of how much each of these factors contributed to the total return of the S&P 500 Index for calendar 2024 and for the ten years through the end of last year.

Most of the index’s 25% total return last year (that is in U.S. dollar terms) was the result of investors’ optimistic speculation – quantified as changes in the P/E ratio. Represented as the blue bar segments in the above chart, this refers to investors’ expectation that earnings growth will accelerate in the future. This portion of the return is known as the speculative component because it reflects expectations for the future. In bear markets, expectations are gloomy, and the P/E ratio usually falls sharply. In bull markets, the exact opposite occurs – earnings tend to grow and the P/E ratio often rises, causing strong surges upward for stock markets.

Future Returns (2025-2034)

I estimate that in the next ten years, we will see much lower returns for the S&P 500 Index. My expectation is best illustrated using the analysis behind the above chart. Let’s say, for instance, that the strong earnings growth that S&P 500 companies have experienced over the past decade repeats in the next ten years. Let us also assume that inflation is about the same over that period.

The S&P 500 Index ended last year with a price-to-earnings ratio of about 28 times. If you expect the future to be as robust as the past, that means total returns of nearly 13% per year. For that to happen – assuming the same strong earnings growth of the past – the P/E ratio would have to balloon from nearly 28 times to north of 40 times. That is possible but highly unlikely in my view. It has happened in the past but resulted mostly from depressed earnings (i.e, the E falling faster than the P in the P/E ratio).

With that in mind, consider three scenarios for the index P/E ratio at the end of 2034 and how that translates to future returns. At the end of last year, the S&P 500 traded just below 28 times earnings. If earnings growth and inflation mirror that of the prior decade – and the P/E ratio ends 2034 where it was a few weeks ago – I estimated that the index will kick out a compounded total return of about 7.5% per year.

I repeated that calculation for two other scenarios – a) the index P/E ratio falls modestly to about 25 times (which is where it was just over a year ago); and b) it falls to 20 times (the level from the end of 2014). I calculated that each of these scenarios would result in markedly lower returns, summarized in the chart below.

A P/E ratio of 20 times is well above the mid-teens (the historical average), so this is no doom-and-gloom scenario. And yet that modest long-term headwind is enough to knock the next decade’s return to one-third of the most recent ten years.

Rising P/E multiples have been a massive contributor to returns over the past year for the S&P 500 Index – and a meaningful tailwind over the past decade. If investors simply lose that tailwind, much more modest returns are likely in store. And if that tailwind becomes even a modest headwind, a mid-single digit total return is more likely.