THE TRUTH ABOUT FUTURE STOCK RETURNS: They’ll Be Crappy (But Better Than Bonds)

The recent bull market has gotten everyone all excited about stocks again.

Last summer, you’ll recall, stocks were crashing, so everyone hated them and thought they would crash more. Then stocks stopped crashing and began to go up a little, so everyone stopped hating them. And now stocks have basically gone up steadily since the October 3rd low on the S&P of about 1,100, so everyone is starting to like them again.

Yes, this is completely bass-ackwards.

Everyone should get more and more excited about stocks the more they crash, because this means that stocks are getting cheaper and will therefore likely produce higher future returns. (The stock market is the only market in the world in which everyone hates the word “SALE!”). And everyone should now be getting less and less excited about stocks the more they go up because they’re getting more expensive, which means that they’ll likely produce lower future returns.

But it has been that way since the dawn of the stock market.


Trying to forecast stock returns over the short- and intermediate-term is a loser’s game, so don’t try to play it.

(You can be intellectually interested in it if you like, and you can analyse forecasts and arguments and try to come up with better ones, but just don’t put big money on it. Because if you make a habit of putting big money on forecasting short-term market returns, you’ll almost certainly cost yourself money in the end).

Forecasting long-term stock returns, however, is generally much easier.

What you need to do to forecast long-term returns is to get a sense of the market’s valuation (price-earnings ratio) relative to normalized earnings.

What are normalized earnings?

Earnings that are adjusted to average profit margins instead of the profit margins of whatever part of the business cycle you happen to be in.

Right now, for example, corporate earnings are near a record high relative to GDP (see chart below). This is because companies have spent much of the last several years firing people and cutting costs and have now become hyper-efficient.

Profit Margins As a per cent Of GDP
Corporate profits as a per cent of GDP.

[credit provider=”St. Louis Fed” url=””]

If today’s super-high profit margins were going to be sustained indefinitely–or increased from here–we could go ahead and use the P/E ratio based on this year’s earnings to forecast future stock returns.


Over all previous history (see chart), profit margins have been what statisticians call “mean-reverting,” meaning that they get low for a while and then they “mean-revert” back to the average, and then they get high for a while and then “mean-revert” back to the average. And so on.

And the problem with using earnings with either super-high or super-low margins as your “earnings” measure in your P/E ratio is that you can get a very misleading picture of the market’s valuation. Specifically, if you use earnings in years with abnormally high profit margins (like this one), the market will look cheaper than it actually is. And if you use years with abnormally low profit margins (like 2009) the market will look more expensive.

So what you need to do is use normalized earnings–earnings calculated using average profit margins.

And what do you find if you do that?

Well, what you find is that stocks are expensive. Not outrageous. Not insane. But expensive.

Using “normalized” earnings, for example, the legendary Jeremy Grantham of GMO estimates that fair value of the S&P 500 is about 950-1000. This is about 25% below today’s level of 1,275.

Now, just because “fair value” on the S&P 500 is below 1,000 doesn’t mean the S&P will ever trade there, so it’s not smart to just sit around waiting until it does.

But what this fair value does tell you, when juxtaposed with today’s level, is that stocks are likely to deliver sub-par returns over the next 10 years.

How sub-par?

John Hussman of the Hussman Funds estimates that the S&P 500 is priced to deliver 5% annual returns over the next decade.

Mr. Hussman also produces this helpful chart, which shows the future forecasted 10-year returns using a “normalized” method (blue line) with the actual 10-year returns. As you can see, they have a tight correlation. And the current 10-year forecast (blue line) is predicting about 5% returns.

Stock Market Returns
10-year total S&P 500 returns. Forecast = blue line, Actual = red line.

[credit provider=”John Hussman, Hussman Funds” url=””]

5% returns are about half of the 10% “average” returns that the stock market delivered in the 20th Century.

So they’re nothing to write home about.

But here’s the good news.

5% returns are better than the negative returns that we’ve had on the S&P 500 for the past decade.

And they’re also better returns than you’re likely to get from 10-year Treasury bonds, which are currently yielding 2%.

And better than the ~0% return that you’re currently getting on your cash (though this return could increase if the economy improves and the Fed finally raises interest rates).

SEE ALSO: This 15-Year Stock-Market Cycle Signals 4 More Years Of Pain