Three History Lessons Frame Market Expectations

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With markets around all-time record levels and volatility ratcheting higher, while the geopolitical climate becomes increasingly tense, investors are getting nervous. Will the spectacular U.S. bull market come to an end in 2025 or beyond?

The future is impossible to predict, but looking at the patterns around price/earnings ratios can provide some insight about what one might expect.

Lesson 1: Hockey Stick Growth

In the 110-year history of the U.S. stock market, the first 67 years saw no inflation-adjusted capital appreciation. Surprised? Me too.

Since then, it’s practically been straight up by comparison. The most recent 43 years has produced a 1390% return. It’s been a good 43 years, leading to a currently expensive stock market.

Lesson 2: Low P/Es when inflation is not low

Price/earnings ratios are high right now. It’s a very expensive market. Historically, high P/Es have happened when inflation was near zero. When we’ve had either high deflation or high inflation, P/Es were low. If stock prices fall, P/Es will fall. Should that happen, will inflation fall to near zero? Can it?

Why are P/Es low when inflation is not? Fear.

Lesson 3: Low returns follow high P/Es

Regarding high P/Es, Howard Marks observes that "It shouldn’t come as a surprise that the return on an investment is significantly a function of the price paid for it.” As shown in a 2010 post from My Money Blog, the greater the P/E, the lower the subsequent return and the higher the likelihood of posting a lower return. In other words, high P/Es are usually followed by reductions in P/E – regression toward the mean.

The Shiller P/E is currently 35, which is near the highest ever. Focusing on the red circle in the exhibit, when P/Es have reached 35 in the past, stock markets have returned near zero in the subsequent decade. And when P/Es have been above 35, stock markets have suffered losses in the subsequent decade every time.

Increasing stock prices decrease subsequent returns. To state this in an obvious way, overpaying for something reduces your subsequent profit. In this case, a multiple above 35 has always preceded investment losses, so rising prices portend future losses.

Vanguard’s Model Has Disappointing Predictions for U.S. Stocks

Even though US stocks are very expensive by most measures, forecasts for returns in 2025 are near normal – around 10%. Except Vanguard. Here are Vanguard’s forecasts for the next decade:

As summarized in the following, high P/Es have caused the model to predict a below-average 3.8% return on U.S. stocks in the next decade. The long-term average return is 10%.

If these predictions prove to be accurate, investors will be best served by underweighting U.S. Stocks and real estate, and overweighting foreign stocks, commodities and bonds.

Conclusion

Prices can continue to rise, until they don’t. The Roaring 2020s could repeat the painful lesson of 100 years ago, following the Roaring 1920s.

Has Artificial Intelligence changed history? Of course. So did the dot.com craze and other innovations. AI companies make up about 50% of the S&P500, so they are the great hope. Time will tell.

History repeats with technological advances and bursts of irrational exuberance.

Ron Surz is president of Target Date Solutions, developer of the patented Safe Landing Glide Path and Soteria personalized target date accounts. He is also co-host of the Baby Boomer Investing Show. Surz’s passion is helping his fellow baby boomers at this critical time in their lives when they are relying on their lifetime savings to support a retirement with dignity, so he wrote a book, “Baby Boomer Investing in the Perilous 2020s,” and he provides a financial educational curriculum.

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