Post-election euphoria will give way to something drearier.
For a few golden weeks in November, U.S. stock markets loved Donald Trump. As this magazine went to press in late November, equities were in the middle of a record-setting rally that charged Wall Street pundits and strategists with a fresh sense of optimism. Market watchers at Goldman Sachs gs , JPMorgan Chase jpm , and Raymond James rjf cited Trump’s pledge to roll back burdensome regulations and lower corporate tax rates as decidedly bullish for U.S. stocks.
But for investors who study the forces that govern stock prices long term, the outlook was no more upbeat after the election than it was before—and it was far from terrific. Put simply, equities are really, really expensive, and only became more so after Trump’s surprise victory. “The best predictor of future returns is whether you buy at low or high prices relative to earnings,” says Chris Brightman, chief investment officer of Research Affiliates, a firm that oversees strategies for $161 billion in mutual funds and ETFs. “Today individual investors and fund managers who expect the near-double-digit returns we’ve seen over history will be sorely disappointed.”
James Montier, a value investor at asset-management firm GMO, provided this dim appraisal of U.S. stocks: “This is a hideously expensive market, and I don’t need to own it.”
Take a deeper dive into the thinking of pessimists like these, and it’s hard not to reach similar conclusions. (More on that in a moment.) Fortunately, investors can garner much bigger rewards by looking beyond the super-rich American market and beyond stocks in general. This is the time to take a broad, venturesome view encompassing all the best—meaning mainly the cheapest—places to put your money.
For more about the economic challenges facing the Trump administration, click here.
As we’ll see, spreading your portfolio across a broad range of underpriced assets can add crucial percentage points to your returns. Best of all: If you do it thoughtfully, you can improve your odds while shouldering little or no extra risk.
Investing for a Trump Economy
Chris Brightman, chief investment officer of Research Affiliates, thinks that a foreign-centric stock portfolio could outperform a U.S.-only portfolio by as much as three percentage points a year over the next decade. For Fortune’s stock picks in Europe and emerging markets, see our stocks-and-funds story in this issue.
Rising inflation could be a mixed blessing for stocks. But it’s good for investors in floating-rate bank loans (whose interest payments rise with inflation) and TIPS, Treasury securities whose principal rises with consumer prices. For more, see our Investor Roundtable in this issue.
Collect a Check
When stock price growth is sluggish, dividends account for a much bigger share of investors’ gains. The problem: Dividend-paying stocks are historically expensive right now. To find out where professional money managers are looking for bargains, see our dividends feature in this issue.
Let’s examine why the near future for U.S. stocks looks downbeat. Over the past 100 years, the S&P 500 has delivered average annual returns of 9.6%. Wall Street optimists and many pension fund managers believe that past is prologue and that equities will continue to deliver those historical returns. But it won’t happen for a while for one reason: On average the folks who pocketed those nearly double-digit gains in past decades were buying at far lower prices than the big valuations prevailing today.
Here’s why the market math is so daunting. When you purchase a broad swath of equities, say an S&P 500 index fund, the returns you can expect over the next decade or so comprise four building blocks: the starting dividend yield, projected growth in real earnings per share, expected inflation, and the expected change in “valuation”—that is, the expansion or contraction in the price/earnings (P/E) multiple.
Let’s start with the first building block: the dividend yield. The main reason high prices foretell paltry gains is that rich valuations make dividend yields smaller. It’s dividends that have provided the richest rewards to investors. Since 1871, the S&P dividend yield has averaged 4.9%, though it has been lower in recent decades.
The problem is today’s highly elevated P/E ratio. The P/E of the S&P 500 stands at 24; that’s well above the average of 16 over the past century, and 19 since around 1990. Big U.S. companies, on average, pay out half their earnings in dividends. But because the “P” is so towering, you get far fewer dollars in dividends for every dollar you pay for stocks. Today the S&P dividend yield stands at a slim 2%.
So how much will the second building block—real growth in earnings per share—add to that weak yield? In today’s bluebird forecasts for stocks, the biggest fallacy is highly inflated expectations for earnings. “Since the mid-1980s, profits have grown at unusually high rates, giving rise to the mistaken idea that we were in a ‘new normal,’ ” says Brightman. “Earnings rose to a historically high share of national income that they couldn’t possibly sustain.” In fact, the inevitable decline has already begun. S&P profits, based on trailing earnings per share over the past four quarters, peaked in September 2014 and have dropped by 15% over the past two years.
Although earnings careen in a zigzag pattern from year to year, their trend stretching over long periods is remarkably consistent. U.S. profits expand with the overall economy, growing at an annual clip that has exceeded 3% over the past century. But what matters to investors is earnings per share, what they’re effectively receiving in dividends, buybacks, and reinvested profits that drive capital gains. And it turns out EPS expands at just half that rate, or around 1.5%, adjusted for inflation.
The reason for the big lag is twofold. First, companies constantly issue new stock to reward executives and make acquisitions, and the new issues far exceed buybacks. Those extra shares dilute the portion of profits flowing to existing shareholders. Second, new enterprises, often funded by IPOs, invade their markets and reduce the incumbents’ share of the industry’s profit pie. “Profits can grow above trend for certain periods, but they’re still elevated,” says Brightman. “The best assumption is that they grow at the historical real rate of 1.5%.”
To sum up so far: A 2% dividend yield, plus the 1.5% projected EPS growth, should deliver a future real return of 3.5% a year for the next decade. Add the third building block, the approximately 2% inflation predicted by the Fed, and the total expected return on big-cap U.S. equities comes to just 5.5%.
For more on Trump and the Economy, watch this Fortune video:
The fourth building block, expected change in the P/E, is a cause for concern. It’s possible that high P/Es are a new normal. Monetary policy in recent decades has been successful in keeping inflation in check, a plus for valuations. And the shift of the economy from volatile manufacturing to a relatively steady service sector has added stability to revenues. Still, it’s unlikely that a P/E of 24 will rise further; indeed, it’s more likely in danger of shrinking, in which case stocks would take a beating.
Bottom line: Even under the optimistic assumption that for the next decade P/Es stay about where they are today, the expected return on equities remains 5.5% a year—the sum of the dividend yield and EPS growth, including inflation. What’s more, to dampen risk, many investors will want a balanced portfolio of stocks and bonds; the classic mix is 60% equities and 40% fixed income. With the current yield on the 10-year Treasury at 2.2%, the expected return of the 60/40 blend comes to 4.2%—and that, too, is disappointing compared with the historical average of 7.6% for that asset mix.
It’s safe to assume a 4.2% return isn’t what average Americans need to swell their nest eggs for retirement or propel their college savings plans. What to do? To boost returns, go broad and abroad.
American mutual fund investors have an average of around 25% of their portfolios in non-U.S. stocks. But it makes sense to boost that allocation now because years of under-performance have made foreign stocks so much more affordable relative to American ones—in Asia and Europe and in emerging markets from South Korea to Turkey.
The best guide to future returns is the cyclically adjusted P/E ratio, or CAPE, developed by economist Robert Shiller. The higher the Shiller earnings yield, the better the bargain in general. If the Shiller methodology is adjusted using a formula from Larry Swedroe, director of research for the BAM group of investment firms, the earnings yield on developed market stocks excluding the U.S. and Canada is 7.4% net of inflation; for emerging markets, the number is a spectacular 9.2%. For S&P 500 stocks, it’s 3.76%. “You have to be humble—a big range of outcomes is possible,” says Swedroe. “But it’s still the best yardstick we have for future returns.”
To benefit from those big yields, Brightman designed two portfolios that shun U.S. shares in favor of developed and emerging-market foreign equities. The first choice, called Contrarian, is no more (or less) volatile than the U.S. 60/40 mix. It puts 25% into foreign stocks, 25% into U.S. Treasuries, and 10% each into commodities, emerging-market currency, bank loans, high-yield bonds, and 5% each into TIPS and local-currency emerging-market debt. The second portfolio, “Maverick,” places 50% of assets into foreign shares and lowers the Treasuries allotment from 25% to 10%. Brightman expects Contrarian to deliver a 5.8% annual return in the next decade. Maverick is the champ, boasting a 7.2% expected return. It’s a bit riskier than the 60/40 or Contrarian, because of the higher concentration of foreign equities, but its wide diversification across geographies and product groups makes it a still-safe bet.
Despite the Trump euphoria, the fun’s over for a while in U.S. stocks. The investment world is vast, varied, and, outside of America, full of bargains. Over the next decade, investors should learn to say “bull market” in a few languages other than English.
This is part of Fortune’s 2017 Investor’s Guide, which features experts’ picks of 21 stocks and two funds to buy for next year.