For this (veteran) writer, no source provides more data-rich, well-founded, and convincing forecasts for future investment returns in multiple asset classes than Research Affiliates. And what that source now foresees for U.S. big-cap stocks, the comeback kids so far in 2023, is sobering indeed.
Based on its expectations for inflation and earnings, Research Affiliates expects the S&P 500 to deliver real returns of just 2% a year for the next decade—a tiny fraction of their annual returns over the past 10 years.
Research Affiliates is a firm that designs investment strategies for $130 billion in mutual funds and ETFs for such managers as Pimco, Charles Schwab, and Invesco. It created a template called “fundamental indexing” that weights stocks not by their dollar value, but by such bedrock measures as cash flow, sales, and dividends. The firm’s RAFI-branded fundamental funds are hence structured to avoid putting a bigger and bigger percentage of total holdings in the most expensive stocks, a big problem for traditional index funds and ETFs and other “cap-weighted” vehicles where allocations are based on stocks’ market capitalization. RA founder Rob Arnott is the former editor-in-chief of Financial Analysts Journal, and ranks among the top academic thinkers in portfolio management. RA’s CEO and chief investment officer, Chris Brightman, is also one of the leading masters of scientifically based data analysis in the investment industry.
The RA website features an “Asset Allocation Interactive” map that shows the firm’s 10-year total return projections for three dozen investment categories, from emerging markets to REITs, from TIPS to commodities. The numbers are based on the principal of “reversion to the mean.” In predicting changes in valuation, for example, RA forecasts that over the next decade, price/earnings ratios (P/Es) will move from their current levels toward their long-term averages. It also deems that earnings per share will expand close to historical norms, and ignores the bluebird predictions of consistent, double-digit growth usually posited by Wall Street analysts.
Falling P/Es and modest profit growth will mean low future returns
In its table for U.S. large caps, RA predicts that earnings per share (EPS) will rise, on average, at 5.4% a year through 2033. That number equates to 2.5% “real” gains, since RA foresees inflation running at a 2.9% annual pace, well above the Federal Reserve’s 2% target. That 2.5% profit growth figure sounds shockingly low when compared with the period from mid-2013 to mid-2023, when profits beat inflation by an average of 5.2 percentage points a year, but it’s actually pretty good by historical norms. Well-regarded research shows that over the long run, EPS lags GDP as companies make dilutive acquisitions and new entrants drain the sales and profit pools once divided among entrenched stalwarts. The RA view implies that EPS may well “outperform” by expanding faster than the economy; the Congressional Budget Office predicts that GDP will grow at just 1.7% to 1.8% a year through 2033. Hence, RA is taking a sound but fairly optimistic view on earnings.
By contrast, Wall Street analysts are positing that S&P 500 EPS expands by 29% from Q1 of this year through the end of 2024 alone, achieving over 40% of the RA 10-year forecast in just seven quarters.
RA predicts an additional 1.7% annual return from dividends, close to the current yield. Add the dividend yield and projected growth in earnings, and you get 7.1%. But that’s the total return you’d garner if the P/E stays steady at today’s level of 25. By RA’s best estimates, that’s not going to happen.
The firm sees the 500 P/E, based on trailing, 12-month profits, contracting toward its norm of recent decades. But once again, the take is hardly pessimistic. RA foresees a decline in the multiple from 25 to 20.4, a figure that’s around the median for the past 30 years. The almost five-point shrinkage reduces yearly gains in stock prices from the 5.4% they’d register if the P/E stayed at the current 25, by 2.2 points a year, to an annual pace of just 3.2%. Add that 3.2% in annual capital gains to the 1.7% dividend yield, and you get the RA total return of 4.9%.
Where does the RA formula see the S&P 500 index 10 years hence? The net 3.2% annual increase in share prices would mean the 500 hits 6000 in June of 2033, just 37% above its close of 4381 on June 22.
The forecast looks especially bad compared with the past decade
The most important measure is the additional buying power the 4.9% annual gains will give you. At 2.9% projected inflation, the dollars in your portfolio will grow only 2% faster than the increase in food prices, rent, and all other expenses (that 4.9% total gain minus 2.9% projected inflation). Put another way, largely because the starting point for investing in big-caps is so expensive, you’re likely to garner only 2% real, annual returns over the next decade.
Compared with the bounty of the past 10 years, that number seems almost inconceivable. From mid-2013 to mid-2023, the S&P 500 delivered a total, inflation-adjusted yearly return of 10.1%. That’s five times what RA deems most likely for the next decade. Just a hint. Folks and funds could buy the index in Q2 of 2013 at a P/E of 17.6. That’s 30% cheaper than today. Those bargain prices opened the way to the high returns. Moving forward, the opposite dynamic will take charge. Periods of low returns follow episodes of outsize gains. That’s how the market seesaw shifts back into balance. And that’s the grim dynamic likely to reign in the years ahead.
