More investors should be asking about how to invest when stocks are high. The first three quarters of 2024 were the best for the S&P 500 Index since 1997. But what is the outlook going forward for investors?
In a new paper by Goldman Sachs, they project that the return of the S&P 500 Index for the next 10 years, 2024-2034, will be only 3%. How did they reach this dismal projection? The model considers projected earnings growth, current valuations, interest rates, likely recessions, and stock market concentration.
How bad is it?
- The return would be in the worst 7% of 10-year returns since 1930.
- There is a 72% chance that the S&P 500 will do worse than a 10-year Treasury Bond.
- While their median projection is 3%, the 95% confidence range is between -1 and +7%.
The projections from Goldman are quite similar to the analysis from Vanguard. Currently, the Vanguard Capital Markets Model has a 10-year projection of 4.2% for US stocks. Both projections are very alarming, a far cry from the 11% annualized returns of the S&P 500 over the long-term.
Which Projections Matter?
In the short-term, markets are really impossible to predict. Long-term investors should not make portfolio decisions based on short-term projections. I remember one firm said there was a 100% chance of a recession in 2023. But it never happened. Short-Term predictions can be wrong and there are too many variables and surprises to consider. No one has a crystal ball and short-term predictions are about as accurate as guesses.
Long-term projections, however, may have some value in that there can be an eventual reversion to the mean. Periods of above average performance are often followed or preceded by below average performance. If you start with stocks being very expensive, then often the following decade has below average returns. And when you start with cheap stocks, like we had in 2003, March of 2009, or March of 2020, the following periods are typically above average.
Our approach is to ignore the noise of quarterly or annual projections. But we do position our portfolios towards the long-term trends of what the historical evidence suggests, based on today’s situation. We are not going to attempt to time the market, but we are going to listen to what market history tells us. Let’s talk about three ways investors can position their portfolios for a potentially low-return decade ahead.
Which Equities?
While both Goldman Sachs and Vanguard have low projections for the whole market, both also see opportunities in certain areas. The S&P 500 Index has been a great performer over the past decade, but other categories could do better over the next decade.
Goldman’s analysis believes that the current market concentration will be a major detractor from performance. What is market concentration? The biggest stocks have become the most overvalued, and the weighting of the largest 10 companies is exceptionally high today. While the regular, cap-weighted S&P 500 returns are projected at 3%, Goldman projects that the equal-weighted index could return 7%.
What is an equal weighted index? An equal weighted index invests the same dollar amount into each stock. If there are 500 stocks, each has a weight of 0.2%. And there is an easy solution here, because we can invest in an Equal Weighted Index fund.
Vanguard also expects better returns when we look outside of the US Growth segment. Here are their 10-year median return projections:
- US Growth: 1.1%
- US Value: 5.7%
- US Small Cap: 6.0%
- Developed ex-US stocks: 8.0%
This is why we diversify. Past performance is no guarantee of future returns. Even with the low projections for the entire market, there can be categories which could do better. This is the first strategy: diversify away from growth and cap-weighted indexes, and towards the areas with higher expected returns, such as equal-weight, value, small-cap, and international stocks.
DCA and Rebalancing
If you are a younger investor, I don’t want you to look at these reports and think you should forget about investing. The market will not go in a straight line over the next decade and there will undoubtedly be both large drops and large rallies. If you are investing monthly into your 401(k) or IRA, keep doing that. You are dollar cost averaging (DCA) and can benefit from all the volatility. Focus on your accumulation and diversify into low cost index funds in many categories.
For larger portfolios, even a relatively low-return environment can benefit from rebalancing and ongoing portfolio management. In fact, it is during long bull markets that rebalancing is the least helpful. In volatile markets, rebalancing allows us to benefit from the differences between stocks and bonds cycles. With rebalancing, we can sell stocks when they are high (like now) and buy stocks when they are low (like we did in March of 2020). This is part of our ongoing risk management process.
Bonds
Our third pillar of investing in a low-return environment is Bonds. Bonds are back. Our approach is to buy individual high-quality bonds and ladder them for five years. This means we have the bonds in place that will mature each year to meet the cash flow needs of our clients. For retirees, this means we do not have to touch our Equities to meet income requirements when the market is down. This gives us additional flexibility rather than always having to sell Equities to meet withdrawal needs. We want to create certainty with our bonds: income and capital preservation.
More conservative investors may find that this is an opportune time to overweight bonds and have more predictability in their portfolio. We can still get up to 5.4% on a 5-year fixed annuity today. That remains a compelling safe return. Most of the time, people are expecting to get 10% in the stock market. But if we are only expecting to get 3% to 5%, then it hardly seems worth it to take the gamble on stocks. Today, the expected return of a portfolio that is 80% stocks and 20% bonds is hardly different from one with 40% stocks and 60% bonds. Historically, those two portfolios are very different, but not today. Unfortunately, however. there will be a lot more volatility with 80% stocks than 40%.
High Stock Market Equals Low Returns
This can be a difficult lesson for investors to accept. Our natural tendency is to project the current returns into the future and assume the bull market continues. And maybe it will for a while longer. But long-term investors should understand that when the stock market is high that means projected returns are low.
Thankfully, we have a plan and our portfolios reflect the long-term outlook. We diversify into other categories with better expected returns. We dollar cost average and rebalance. And we consider the role and weighting of bonds for each client’s needs. There is no doubt that the projections from Goldman Sachs and Vanguard will prove to be imperfect. The future is always an unknown. Our plans will change, evolve, and adapt. But our focus will remain on doing our best work for planning and creating a portfolio strategy using the information, evidence, and research that is available.
