Financial Markets & The Economy Archives - Setarcos LLC

The S&P 500. It’s been a great 10 years. Don’t expect a repeat.

evanhall — Wed, 15 May 2024 11:00:52 +0000

Updated: May 15

The S&P 500 (the ‘S&P’) has been on a tear in recent years. During the 10-year period ending March 31, 2024, the S&P averaged 13.0% per year (including dividends). That is a great return. With the exception of the NASDAQ, it’s beaten nearly every benchmark out there. As we noted in a year-end letter to clients in December: “Consequently, any equity portfolio holding something other than US large cap stocks has likely not performed as well as the S&P. That has been the curse of diversification over the past few years.”

So, what happens next? Why not just put everything into the S&P today? It’s done so well, right? It has. And that’s kind of the problem.

Because it’s done so well recently, the odds of a repeat performance (another 13% per year for the next ten years), at least in our view, are low. In fact, I think a reasonable expectation for what we’ll get over the next 10 years (starting on April 1, 2024) on the S&P is somewhere between 4% and 7%. I’ll explain why below.

But first, some background.

Stock returns (whether an individual stock or an index) come from the combination of three things:

Dividends
Growth in earnings per share, and
The change in the valuation attached to those earnings, measured by the change in the PE ratio

That third item, the PE ratio, requires a bit of explanation. The PE ratio is just the current price divided by the last 12 month’s earnings. It can be affected by a variety of things (e.g., market psychology, interest rate expectations, perceived business risk) but generally interpreted as the market’s expectations for future earnings growth. If the PE ratio is high, growth expectations are generally high. If the PE ratio is low, growth expectations are generally low.

The PE ratio is kind of the wild card in our little returns equation above. When it goes up, it helps returns and when it goes down it hurts them. There’s a catch though. the PE ratio cannot go forever up or forever down. It moves in a range. And it tends to be mean reverting.

Over the long term, what the PE ratio giveth, the PE ratio tend to taketh away (and vice versa, of course).

So, what did the S&P PE ratio do over the past 10 years? It increased from about 18 to about 27[1]. That helped returns a lot. In fact, I estimate that about one third of the 13% return on the S&P over the past 10 years came courtesy of that increasing PE ratio. Not dividends. Not earnings growth. Just increasing valuations.

The PE ratio has been in giveth mode over the past decade.

Here’s why that’s not likely to continue:

Remember our formula above: returns = dividends + earnings per share growth + PE ratio change (this sum is not exact due to the math of compounding, but I’ve corrected for that in my calculations). Let’s use that formula to see what the PE ratio would have to be 10 years from now to get another 13% per year return over the next decade starting April 1st this year.

The current dividend yield on the S&P is about 1.4%. That’s a reasonable estimate for what we should expect from dividends over the next 10 years.

The S&P’s earnings per share (including inflation) grew a bit less than 7% per year over the past decade so let’s assume we get 7% over the next 10 years (which, incidentally, would be very good – I’ll return to this point at the end).

Add those two and you would get returns of about 8.4% over the next decade. But wait, we want 13%! That means we need an increasing PE ratio.

To get 13%, the S&P PE ratio would need to go from about 27 today to about 41 ten years from now. How likely is that? The only time the S&P PE ratio has been above that in the past 35 years is in the aftermath of the tech bubble in the early aughts and the aftermath of the Great Financial Crisis in 2008-2009.

What if, instead, the PE ratio goes down over the next 10 years? Let’s say it comes back to a more normal-ish value of 20 ten years from now. If that happens, your total return over the next 10 years on the S&P would be about 5.2%. By the way, I picked 20 because about 70% of the time over the past 35 years it’s been between 15 and 25.

Now, could PE ratios stay higher for the long term? Of course. There are good arguments for this (think tech-enabled business models here: less capital intensive, higher return on equity). But assuming they stay higher is a bet against history. Who wants to take those odds?

Let’s look at another measure. Check out the following chart of the Shiller Cyclically Adjusted PE ratio over the past 20 years. The Shiller PE is a widely used modification of the traditional PE ratio meant to average out the short-term noise of earnings volatility associated with business cycles. Like the normal PE ratio, the Shiller PE moves in a range (i.e., it doesn’t go up or down forever, and it tends to be mean reverting).

Note where the Shiller PE is as of March 2024 compared to where it was 10 years ago. It’s increased from about 25 to about 34. Over the past 140 years or so (yes, 140 years), the Shiller PE has been higher than it was on March 31, 2024 on only two other occasions: in 2021 and in the late 90s tech bubble (not shown in the chart).

What would the Shiller PE ratio have to be 10 years from now for us to get another 10 years of 13% annual returns from here? Let’s use the same assumptions as above: dividend yield of 1.4% and earnings growth of 7%. We also have to make an inflation assumption for the Shiller PE ratio calculation, so I’ve assumed 2.5% per year.

Based on my calculations, to get 13% over the next 10 years would require the Shiller PE ratio to hit about 50 ten years from now.

It’s never hit that level. Not in 140 years. Not even in the 90s tech bubble (which was the highest it ever hit). Still, is it possible? Yes. Is it likely? Do I need to answer that?

What if the Shiller PE ratio comes back down to something a little more normal (by recent historical standards)? Let’s assume it’s at 25 ten years from now. If that happens (and using the same dividend and earnings growth assumptions from above), the total annual return on the S&P over the next ten years would be about 5.5% (very close to our estimate using the normal PE).

At this point, it might be tempting to say, ‘well, fine, I get that valuations are high, but I think earnings will grow faster than 7%’. Maybe, but I think that’s unlikely also. Corporate profits are a component of GDP and those are already near historically high levels as a percent of GDP. To have those grow faster, you need GDP to grow faster and/or to have profits become an even greater proportion of GDP. Seems unlikely.

If you’d like just one more data point to chew on, consider this historical tidbit: over the past 30 years, if we look at all of the periods in which the S&P returned 12% or more over any consecutive 120 month period, and then, for those periods, look to see what the S&P returned over the next 10 years, we find the following: the average annual return for those subsequent periods was just 1.6%. And the very best was 7.7%.

The S&P had a great run over the past decade. Just don’t expect a repeat.

To be clear, I’m not saying it can’t happen. Just that it’s not likely.

You know, math and history and all.

[1] I’ve used estimated earnings per share for Q1 of this year (source: S&P) in all calculations since actual results for Q1 have not yet been fully reported.

Disclosures:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index. Past performance shown is not indicative of future results, which could differ substantially. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of Setarcos strategies are disclosed in the publicly available Form ADV Part 2A.

Setarcos Wealth Advisors LLC (“Setarcos”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Setarcos and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at setarcosllc.com.

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Bye, Charlie

evanhall — Thu, 30 Nov 2023 11:00:34 +0000

The first time I heard Charlie Munger’s name was in the late 90s. I was working at an actuarial consulting firm starting to develop an interest in financial markets and investing and someone said, ‘hey, you should check out Warren Buffett and read his shareholder letters’. I did both. Warren had the spotlight, but he talked about Charlie in every letter. He was hard to ignore. For the next few years, though, he was just a name to me. Warren’s ‘sidekick’ and Berkshire’s vice chairman. I didn’t pay much attention to him. That all changed a few years later.

In the early 2000s, I decided to start attending the Berkshire shareholder’s meeting in Omaha. If you’ve never been or seen clips from the meeting, Warren and Charlie sit side by side at a table in front of thousands of shareholders and answer questions (not provided to them in advance). Warren speaks first (unless the question is directed at Charlie) and then, most often, asks Charlie if he has anything to add.

That was the first time I heard Charlie speak. Warren is brilliant. Charlie might have been smarter. Warren would give long, insightful responses to each question. Charlie, if he offered a response, was brief and answered with piercing insight. His responses were to the point and perfectly reasoned. He would quote Marcus Aurelius in one response and then apply the laws of thermodynamics in another. I was in awe.

After that, I started paying attention to Charlie. I read everything I could from him and about him. I started paying attention to the Daily Journal annual meetings (in which he also answered shareholder questions for hours). I read old transcripts from the Berkshire meetings. And, like my experience reading Warren’s letters, my mind expanded again.

Like so many in this business, Charlie, along with Warren, has been a mentor to me. Odd to say about someone you never met, but at least one definition of a mentor is ‘an experienced and trusted advisor’. That fits.

I’ve learned a ton from Charlie over the years, both about how to be a thoughtful steward of our client’s wealth and about how to make myself a better person. How lucky to have had someone like this in our orbit for so long.

I will miss his wisdom and guidance, but I’m grateful for everything he left behind.

Disclosures:

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Is the Fed Doing the Right Thing?

evanhall — Wed, 09 Nov 2022 18:00:30 +0000

I can’t tell you how many articles, blog posts and essays I’ve read on this topic. The majority seem to be pretty critical. And I get it. The Fed was slow to recognize inflationary pressures that were building and now they seem to be taking a sledgehammer (primarily, short term interest rate increases, but also forward guidance [essentially telling the market what they’re going to do] and balance sheet normalization [essentially a reversal of quantitative easing]) to the problem. Although, in all fairness, a sledgehammer is really the only tool they have. And they do have a mandate to fulfill (maximum employment and price stability). So, you give an entity a tool and mandate and tell them use the tool to fulfill the mandate and guess what, they’re going to do it.

Most of the criticism seems to be that they’re doing too much too quickly because (a) inflation is already peaking and they’re behind the curve again and/or (b) their tools generally affect aggregate demand whereas, the critics say, the current inflationary spike is primarily caused by aggregate supply constraints. Maybe, but supply constraint driven inflations tend to also increase unemployment (giving you stagflation) which clearly hasn’t happened (yet, anyway). In any event, we won’t have a verdict on this criticism of the Fed’s actions until after the fact.

Contrary to the criticism, though, I think there are clear reasons for their forceful action now including one in particular that does not get a lot of attention in the popular media.

Before we dig into that, let’s pause here for context on why the Fed’s actions now even matter. When the economy is relatively stable (i.e., not now), we really don’t pay too much attention to the Fed. Why? Because if you look at the data, the Fed’s actions (again, during normal times) generally don’t strongly correlate with subsequent market returns. In other words, although it makes headlines, it’s usually just noise. In fact, Warren Buffett once said “If Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, I wouldn’t change a thing.” Point being, there’s usually not much use in hanging on to the Fed’s every action and word.

But inflation makes things different. High inflation is one of the most corrosive, value-damaging forces in economics. To see an example, just go back to the 1970s. As background, the inflationary spiral back then actually started in the mid-1960s and was accompanied by multiple demand shocks: a large tax cut, significant increase in military spending, enactment of Medicare/Medicaid. In addition, there were significant supply shocks, most notably the 1973 oil embargo. Nixon officially ended gold convertibility in the early 1970s, which was the last vestige of the gold standard (although, contrary to some beliefs, this was more a casualty than a cause of inflation at that time). The point is, there were a lot of inflationary pressures on the economy.

Unfortunately, the Fed, at that time, did not do its job. Between 1965 and 1978, there were two fed chairmen who presided over the economy and neither one appeared to have the fortitude to press hard against inflation. They would raise rates but then pull them down when unemployment ticked up. In addition, the Fed was less independent then than it is now and often appeared to cave to pressure by the White House to ease conditions when the economy appeared to slow down. Because of this, the expectation of high inflation became embedded in the national psyche.

And when inflation expectations go up, you’re in trouble.

When people and businesses begin to expect higher inflation, they make decisions that essentially cause higher inflation. Purchases are accelerated, wages are increased at higher rates, inventories are built up. All increasing prices. Hence the 70s and the economic carnage that resulted. In 2001, Warren Buffett wrote about one victim of this period: the Dow. As he notes, between December 31, 1964 and December 31, 1981 the Dow moved one tenth of one percent… not per year, that was the grand total price gain during that 17 year period. Yeah, inflation is bad.

And so today the Fed is on an inflation-fighting mission with its sledgehammer. And a big part of that is making sure expectations stay in check. Where do expectations sit today? So far, at least, the 10-year expectation appears to be relatively well-anchored around 2.5% (source: 10-year breakeven inflation rate at https://fred.stlouisfed.org/).

That’s good, but clearly the collateral damage is all around. Bonds are having their worst year on record. The stock market is in a bear market. In less than one year, mortgage rates have bounced back to levels not seen in 20 years. All bad, but runaway inflation would be worse. That’s what the Fed wants to avoid. And although the conditions now are much different than they were back in the 1970s, inflation is inflation and the Fed does not want to repeat past mistakes.

So, is the Fed doing the right thing? I don’t know, but at least expectations aren’t out of control. Let’s hope it stays that way.

If you’re interested in reading more about monetary policy in the 1970s vs today, Ben Bernanke’s recent book provides a good summary.

Disclosures:

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Volatility, Shmolatility

evanhall — Wed, 01 Jun 2022 18:30:03 +0000

Updated: June 1, 2022

“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”
– Warren Buffett

In the investing world, there are a million and one ways to define risk. Ok, not really. But there are a lot. Get a group of investors in a room, ask them each to define risk and you’ll likely get a handful of different responses. The most common definition is volatility. Stocks, for example, are considered risky because they are volatile. But if you’re a long-term investor, does volatility really matter that much? Aren’t there more relevant ways to think about risk?

Yes, yes there are.

If you’re a long-term investor, another (and, we would argue, better) way to define risk is the probability of having a permanent loss of capital. This happens when, for example, you sell something for less than you bought it. If you buy something and it temporarily declines while you still hold it, you have volatility but you have not had a permanent loss of capital.

Think about this in the context of a portfolio of stocks.

Let’s say you have a ten-year investment horizon and hold a diversified basket of stocks through an S&P 500 index fund. If you have absolutely no need or plan to sell anything from this portfolio over the next ten years, then, using the definition of risk laid out above (i.e., that risk is defined as a permanent loss of capital), this portfolio has low risk. Why? Because, over a ten year period, the probability of having a permanent loss of capital is low. Going back to 1950, there has been only one ten-year period (looking at calendar year returns) in which you would have lost money by selling after 10 years (2000 – 2009, towards the high of the dot-com bubble and low of the 2008-2009 financial crisis). In other words, historically speaking, there was about a 1.4% probability of losing money over a ten-year period. Now, there are a bunch of caveats to this, including that the future could easily be different than the past, that I’ve ignored intra-year holding periods and that inflation will take away part of your return. Still, you can see the odds are strongly in your favor if you have a ten-year holding period. What about other holding periods? Check out the chart below.

As you can see, once you extend out to about 10-15 years, the historical likelihood of having a permanent loss of capital has been quite low.

So, if you’re a long-term investor, don’t fret about the daily, weekly and annual ups and downs of the market. Ignore the silly talking heads who tell you where the market is going this year (hint: they have no clue). None of this matters to you. What matters is where markets are ten to fifteen years from now. And based on history, although there are certainly no guarantees, the odds are highly in your favor.

John Bogle, the founder of Vanguard, was definitely on to something when he said, “The stock market is a giant distraction to the business of investing.”

Disclosures:

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