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A few weeks ago, Goldman Sachs published a long-term return forecast for US equities that caused a bit of commotion in the financial world, or at least among the investing nerds like me.
If you’ve been following me for a while, you know full well that I’m not a believer in predicting the future, but I do think Goldman’s research report has a few elements that make for interesting conversation.
In this episode, we are going to talk about:
- How one goes about forecasting future returns in the first place
- The implications of potentially lower returns in US markets over the next decade
- And throughout the episode, I’m going to share some considerations that ought to go into your portfolio construction
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How Does One Forecast Future Returns?
For most people, it’s roughly the same way we explain past performance:
- Changes in earnings per share
- Changes in cash paid to shareholders via dividends and buybacks
- Changes in valuation
You can dissect any past period of returns and attribute the returns to these three factors.
For example, the S&P 500 earned an annualized total return of 13% during the past decade. Roughly a ¼ of that came from dividends and just over half came from earnings, with the remainder of return coming from expansion in valuation.
Okay, so that’s past returns…
In the case of Goldman Sachs, they outline five variables in their modeling of prospective long-term equity returns: starting absolute valuation, stock market concentration, economic contraction frequency, corporate profitability, and interest rates.
The headline projections is what drew attention from a lot of people: Goldman estimates the nominal total return for the S&P 500 during the next ten years to be just 3% (7th percentile since 1930) and roughly 1% on a real basis.
That’s noticeably lower than the 13% annualized total return the S&P 500 posted during the past decade and the long-term 11% average.
Will S&P 500 Concentration Impact Future Returns?
Going beyond the headline, there are a number of things I found interesting in their commentary.
For starters, Goldman suggests their forecast would be four percentage points higher if they excluded market concentration “that currently ranks near the highest level in 100 years.”
I explored the issue of market concentration in the S&P 500 in Episode 146: Is the S&P 500 Too Concentrated? and emphasized a similar point as the Goldman research, which is that it’s extremely difficult for the largest companies to deliver outsized returns for a prolonged period of time.
Reading directly from Goldman’s research report: “Our historical analyses show that it is extremely difficult for any firm to maintain high levels of sales growth and profit margins over sustained periods of time. The same issues plagues a highly concentrated index. Furthermore, the risk embedded in high concentration markets is not always reflected in valuation.”
The chart below from Dimensional Fund Advisors drives home this point really well.
- From 1927 to 2023, the average annualized return for these stocks over the three years prior to joining the Top 10 was more than 25% higher than the market.
- Five years after joining the Top 10, these stocks were, on average, underperforming the market— a stark turnaround from before. The gap was even wider 10 years out. −1.5% 10 years after
Market concentration is not a new phenomenon and it’s no reason to panic.
In fact, Michael Mouboussin somewhat recently made an interesting case that market concentration is simply a common feature of a bull market!
So what should you make of all this?
I think the goal of navigating the market concentration within the S&P 500 isn’t just to avoid risk but to understand and manage it. Looking beyond the market-cap-weighted S&P 500 to other indices or diversification strategies could mitigate some of these concentration risks.
Within the U.S. alone, diversifying beyond the S&P 500 could involve including mid-and small-cap stocks or adding intentional factor weights.
Prudent investors should also have international market exposures to offset some of the concentration risk.
Should we have a ten-year period where the S&P 500 has an average annualized total return of just 3%, history has shown that developed markets have been an important source of return.
In fact, in periods where the S&P 500 has returns below 6%, international stocks outperformed 94% of the time. It’s when the S&P 500 has returns below 4% that international stocks have outperformed every such period in history.
Will Bonds Outperform Stocks During the Next Ten Years?
Speaking of diversification, another comment in Goldman’s report that I find particularly interesting for conversation:
“Our forecast suggests equities will face stiff competition from other assets during the next decade. Our 3% annualized equity return forecast combined with a current ten-year US Treasury yield of 4% and ten-year breakeven inflation of 2.2% suggests the S&P 500 has roughly a 72% probability of trailing bonds and a 33% likelihood of lagging inflation through 2034. (Excluding concentration, the probabilities of underperforming would be 7% and 1%, respectively).”
One of my favorite slides in Plancorp’s Quarterly Market Review lists three periods that have something in common:
- 1929-1943 (15 years)
- 1966-1982 (17 years)
- 2000-2012 (12 years)
These are all decade-plus periods in which the S&P 500 underperformed Treasury Bills!
T-Bills can basically be thought of as cash, so underperforming cash is probably more psychologically taxing than underperforming bonds, but both would be tough to live through.
But that’s exactly why I like this conversation—it forces us to remember things that have happened before and seem perfectly reasonable to expect will happen again in the future.
It Doesn’t Happen Often, But It Still Happens
The last thing I want to point out is that a period of returns like what Goldman is predicting has just occurred in only 9% of all rolling 10-year periods for the S&P 500 going back to 1935.
It’s not the low historical frequency that grabs my attention, though. Those three decade-plus periods I referenced earlier in which cash beat the S&P 500 makes me reasonably confident we will live through another such period at some point.
But the thing about such periods of low returns is that they (as Datatrek Research’s Nicholas Colas notes) “always have very specific catalysts which explain those subpar returns.”
Without a crisis of some kind, it’s difficult to envision such poor returns over the next ten years.
On the other hand, a crisis typically comes from something that nobody is thinking about. As Carl Richard’s so eloquently puts it: risk is what’s left over after you thought of everything else.
What Does This Mean For You?
For the true long-term investor, lower expected returns in the S&P 500 really doesn’t mean anything.
A prudent investor should design their portfolio at the onset to account for unpredictable periods of good and bad performance. And long-term investors should expect downturns to occur with a similar magnitude and frequency as they have in the past—all while accepting that there is no way to predict them.
If you’re sitting in a portfolio that is dominated by US Large cap exposure, congratulations on the fantastic performance you’ve experienced over the past decade and really since the end of Great Financial Crisis, but it may be time to think about diversifying your US exposures as well as bringing your International and Emerging Market exposures closer to market weightings.
Resources:
- Goldman Sachs Long-Term Return Forecast for US Equities
- Episode 146: Is the S&P 500 Too Concentrated?
- Dimensional Fund Advisors
- Stock Market Concentration: How Much Is Too Much?
- Plancorp’s Quarterly Market Review
- 3% Stock Market Returns For the Next Decade?
The Long Term Investor audio is edited by the team at The Podcast Consultant
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