A Bear Case For Future Stock Market Returns

Future stock market returns

The topic of future stock market returns has got to be one of the most popular stones of contention in the personal finance community.

Everyone agrees that historically, those returns looked pretty damn good, as illustrated by my one of favourite charts:

Annual investment in the S&P 500

That being said, the world has changed.

Things ain’t as good as they used to be, the past does not predict the future (and will you PLEASE look at Japan!)

This isn’t a theoretical argument, either.

The beauty (and danger) of compounding is that over long periods of time, even tiny changes in returns can have an outsized impact on performance:

Return comparison

When striving to build wealth and reach financial independence, it’s best to focus on the journey and not the outcome.

Still, it is also quite helpful to know how long the journey will take, even approximately. And for this, you’ve got to stick some kind of a value in the “returns” cell of your net worth spreadsheet.

Admittedly, I am an optimist by heart.  Life is much easier to live if you don’t expect to get whacked by a baseball bat every time you pass a dark alleyway.

Even so, I struggle to see future stock market returns exceeding 10% going forward.

Here are four reasons why.

#1: Valuations

Let’s start with the elephant in the room:

S&P 500 Historical P/E Ratio

S&P 500 PE Ratio

Over the past 100+ years, the mean P/E ratio for the S&P 500 stood at around 16x, give or take.

You don’t need to be a genius to figure out that today’s levels of 40x+ are not sustainable.

However, you could also make a very strong argument that valuations don’t really matter in today’s environment.

First of all, you’ve got to account for whether the P/E ratio you are looking at is backward or forward-looking.

For example, the chart above uses trailing twelve months’ earnings, which have been significantly depressed.

Covid is obviously a big reason. However, management teams have also contributed here, taking every single write-off possible in order to ensure the recovery looks as robust as possible.

On the contrary, a forward-looking ratio (based on the next twelve months’ earnings) stands at about 21-22x right now, depending on which estimates you are looking at.

Still well above historical averages.

That being said, large swathes of the economy are just beginning to recover from the pandemic. They certainly won’t be firing on all cylinders over the next year.

For all we know, by the time the dust settles valuations might not be as big of a problem as people think right now.

#2: Life Expectancy

The topic of longer lifespans and the impact it has on our return requirements doesn’t get nearly as much attention as it should.

Imagine a twenty-year-old who knows they might not be around to see his thirtieth birthday.

Not exactly an ideal stock market investor, what with the long-term horizon and the need to ride out booms and busts to enjoy a wealthy retirement.

And to the extent such a twenty-year-old would entertain investment opportunities in the first place, you can rest assured his return expectations would be far north of the 10% delivered by the market in the past.

Now imagine a world where life expectancy goes up to two hundred years.

Rest assured that two things would happen in pretty short order:

  • Investors would become much more tolerant of risk, given they’ve got a much longer investing horizon; and,
  • Investors would accept a much lower return, given the impact of compounding

Over the past 70 years, the life expectancy in North America has gone up about 20%, from just under 70 to around 85 years.

Life Expectancy as a predictor of future stock market returns

Source: Wikipedia

For all we know, that could well be a driver of lower return requirements which in turn leads to higher valuations we are seeing today.

And that’s before you consider emerging markets, which have seen an even more pronounced increase in life expectancy and are contributing an ever-increasing share of equity inflows.

#3: Democratization Of Investing

It’s all fine and dandy to look at charts like the one at the beginning of this post.

Wouldn’t life be grand if we could all go back in time and start investing back in the 1930s or even 1950s?

But let’s not forget what equity investing actually entailed back in the day.

First of all, you had to be relatively affluent – certainly affluent enough to have a bank and brokerage account and execute minimum order sizes (100 shares at a minimum).

Second of all, you had to be educated enough about investing (remember – this is before the era of wonderful investing blogs like this one!)

Provided you cleared the first two hurdles, you also had to bear much higher costs.

Things always look easier in hindsight, but no one talks about $100+ trade fees, egregious mutual fund fees (no index funds, remember?), and high brokerage costs.

Yes, the market delivered historical returns of 10%+, but a big chunk of that disappeared in the pockets of all the finance industry intermediaries.

For all we know, while overall market returns have trended lower over time, investor-level returns might have been insulated by a corresponding reduction in investing costs.

#4: Fewer Busts

For a long-term investor, staying the course through stock market corrections is by far the biggest driver of returns over time.

At the very least, you should not sell or pause your regular contributions.

But it’s those investors who actually rebalance into equities during rough stretches (easier said than done) that see outsized returns on their investments.

The real money in the market isn’t made when the skies are blue. On the contrary, wealth is generated in periods like the 1930s, 1970s, late 2000s, and most recently, March – April 2020.

As central banks and governments have become more effective at preventing deep market drawdowns – and more willing to do so, opportunities to buy equities on the cheap have been drying up.

Last year’s Covid crash was the shortest bear market in history.

While some folks managed to load up on equities, many others had been caught flat-footed, missing out on one of the best entry points in recent history.

A chance to drive outsized long-term returns, gone with the wind.

No Guarantees

As ever in investing, it might be helpful to take things with a dose of pragmatism.

First of all, while we can have a hunch about how things will unfold in the future, absolutely no one knows what is actually going to happen.

Perhaps technological progress will usher us into an unprecedented age of prosperity, which will ultimately lift asset values worldwide.

But even if that doesn’t happen, the bottom line is that we really haven’t got that many options.

Yes, there’s real estate.

There are also bonds, but their role is to absorb the shocks, not to build long-term wealth.

Which leaves the stock market as your best option to create sustainable, long-term wealth.

My personal hunch is that the chances of future stock market returns exceeding 10% going forward are pretty slim.

Equally, I don’t feel that the 5 – 6% range some folks advocate is reasonable either.

Applying a haircut of 40% – 50% to historical performance just feels too onerous. Adjusted for inflation, that would imply real returns somewhere in the 2-3% range.

This is why I use 8% for my own planning purposes, as well as here on the blog.

You may well want to take a more conservative view. There is some benefit to being surprised on the upside.

But the broader point to remember is that lower future stock market returns don’t necessarily spell doom and gloom for your portfolio.

There are proven, effective strategies to mitigate against the above.

However, it all starts with acknowledging, and planning for the possibility that future stock market returns might not be as good as they were in the past.

Thank you for reading – and happy investing!

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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker.  I am passionate about capital markets, behavioural economics, financial independence and living the best life possible.

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21 Comments

  1. Completely agree. Even if returns are going to be weaker over the next decade, there aren’t too many other options. I use REITs and gold as diversification options and I do (controversially) have some crypto as a “fun” buy, but equities are pretty much the backbone of any portfolio now and I don’t think there’s a better core option.

    I’m pretty lean in my approach to FI so it shouldn’t be too damaging for me either way, but ultimately there isn’t much choice in the matter: equities and index funds are going to be the main tool for FIRE investing for a long time.

    I’m curious: has the pandemic changed your strategy for FIRE at all?

    • Interesting you should mention crypto. I’ve been forming a view on it for a while now, looking to make it an additional pillar of my investing strategy (focus on investing, not speculation).

      No real change as a result of the pandemic. What impacts my plans the most is the realisation that my kids are growing up quickly and the desire to spend as much time with them as possible over the next 5 – 10 years.

      • Isn’t crypto way to young to form an investment strategy?

        Crypto feels like we are in a pre-currency phase where the basic cash has been printed and we haven’t worked out the system to use it, except thousands have printed their own version of cash and all trying to convince us their one is best, yet none of them have worked out the how it is used.

        There is only one reason crypto is working right now and that is people believe it has value and the religion like marketing that crypto bulls push 24/7 and the market manipulation etc. All the seven principles of influence are being used to manipulate people, even my non-techie mother is talking about, so how many buyers are left, I think we all know what will happen next.

        I’m not a banker and know relatively nothing about the technicals but crypto looks and smells like pure speculation to me.

        • I don’t disagree.

          My focus is finding a way to play on the underlying blockchain technology as piling into the next coin isn’t a strategy (as you rightly point out).

          Ether seems to be one way to do so but I haven’t yet fleshed out my thinking.

          Very keen to compare notes with you and other readers once I put my thoughts down on paper.

      • Correct.

        Also, the bond market as a whole is significantly larger in market cap than the stock market. Last time I checked, it was roughly 1.5x the size, though it may have changed as valuations moved.

  2. What’s your view on moving some of the equity investments to a ‘wealth preservation trust’ like CGT? They seem to be perma-bears but have a decent track record of returns. Their 5Y return chart looks unbelievably smooth, considering the various asset classes.

    • I’ve come across many of these asset managers in my day job over the past 10 years.

      Trust me when I say that while they are smart people, I haven’t seen any secret sauce that will allow them to exceed the market returns by a margin that would justify the fees.

      The folks with a REAL angle (I’ve met a few of those, too) fly under the radar and don’t usually take other people’s money.

  3. The only real protection is to just have a bigger portfolio. But that’s going to be hard to do if future returns are lower. It’s a shame so many other boomers didn’t or couldn’t invest enough. In our case we don’t care if stocks mimic Japan, we’re fine. I mean we care for others, but we no longer need growth for ourselves.

    • I think that’s right – bigger portfolio or lower income needs in retirement (via a later retirement, other income etc.)

      Boomers did have it good but equally I am sure there were other challenges (including the fact that you didn’t necessarily have low-cost index funds at your disposal)

  4. In my opinion, getting rid of trading commissions was one of the most impactful events in stock market history. It changed everything.

    On one hand, it allows people to have access to investments that were unavailable before. Good.

    On the other hand, it no longer requires knowledge to be an investor. People are much more liable to get burned without the proper knowledge. Bad.

    Numbers hardly seem real anymore. Will be interesting how people react if a Japan-like situation occurs in the future.

    • I’m pretty sure the reaction is going to be universally negative 🙂

      My view is that democratisation of investment is a wonderful thing. The folks who will get burned would have likely gotten burned elsewhere.

      However, millions of others now have access to the most wonderful wealth creation machine ever.

  5. It’s not really a question of lower returns but what we are prepared to pay for a $ of profits.

    Start with a given, companies make profits, how do we price a share of a companies future earnings? In a market where there seems to be few alternatives to equity investing and that if prices go down, it’s expected that they will bounce back, why should there be outsized returns.

    • Yes, that’s the valuations bit at the start of the post.

      The “earnings multiple” of cash or bonds are well north of 100x these days (i.e. it you need to buy a $100 instrument to generate $1 of returns given yields are near zero).

      In that context, equity P/E multiples don’t look as expensive as they do on a standalone basis.

      That being said, they are unlikely to expand much further.

  6. People are assuming a deadly virus free future. My guess is that there is a less than 20% probability that the world population will begin to permanently decrease. Less people would be deflationary unless the guv prints money excessively. In a recurrent pandemic world, investlemtns may be illusory.

    • Tough to say what will happen going forward.

      I’m pretty optimistic/hopeful that we’ll find a way into a virus-free future – including viruses as tools of war!

  7. A different voice here. I have seen the S&P500 P/E chart being used by everyone trying to call out that we have an overheated market and the sky is falling down. No problem with that as we are all trying to make decision using data that we have.

    I have to say that your analysis is very logical but I have slightly different view on the S&P500 P/E chart. I say the market is priced very fairly today given what we know.

    The simple assumption that I am going to make is that at end of bear market, the price is always going to be very depressed because most people sold out at the very bottom giving in to the stress. It’s almost a lowest floor level. If we look at the previous 2 bear markets, the P/E at the very bottom is ~15x of depressed earnings. Since both bear markets were more than 1 year long the earning was beaten badly over the same period of time. Even when they eventually recovered, the P/E stayed at the same level for years because people were hesitant to buy in while earning pick back up, until the P/E reach the next spike.

    If we look at the second half of 2010-2020 bull market, the P/E stayed at about ~22x, which to me looks to be a healthy level knowing that 15x is the absolute bottom that we hit over last 2 Big Bad Bears.

    You also pointed out that forward looking P/E is about 22x which is right at the average. So short of anything that can trigger a stampede that bring us down to 15x with deflated earning, we should be fine.

    • I broadly agree with you, though I would be more comfortable with P/E ratios of 18-19x (based on normalized, forward-looking earnings)

      22x is getting you close to a 50% premium to the depressed levels, which feels a bit rich. But on a normalized basis, that metric is probably sub 20x.

      It’s also interesting that the average long-term P/E multiple (c.16x) is not far off the bottom levels we’ve seen in recent bear markets!

  8. As long as you invest in strong companies with good balance sheets, strong free cash flow yields, good return on invested capital, and strong earning growth. Companies with low price to sales and price to earnings multiples. Earnings multiples closer to the historical average PE of 15x along with strong diversification into many asset classes should be able to beat the market over long periods of time. Returns are definitely going to be lower for next few years just because most of the market is trading about 22x forward earnings while they should trade closer to 15x. Eventually multiples will contract as valuations are currently at all time highs and won’t stay this elevated forever. The stock market is still going to be pretty much the only place to put money so I still think stocks are a much more attractive place to be rather than fixed income as returns will still be better, even if they are a bit lower than the usual annual return.

    • I’ve got a pretty strong opinion on anyone’s ability to beat the market (read: slim to none)

      That being said, I fully agree with your last point – what’s the alternative? Not fixed income (good for protection, not so much for yield). Perhaps property, but not everyone wants to be a hands-on, direct real estate investor.

      This leaves the stock market as the only option, notwithstanding the possibility of lower returns going forward.

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