No. of Recommendations: 27
Are you seriously suggesting that people with a 10-year time horizon should avoid the stock market and read a pessimistic academic paper? Sorry, that's just bad advice. I'm telling my kids to do the same thing I did - put 10% of their paycheck into their 401Ks invested 100% in an S&P 500 index fund.
The numbers are pretty simple.
Ultimately, over the long run, the value of the broad cap-weight US stock market is going to track the after tax profits of that set of companies.
There will be times it's more expensive than usual relative to the entire stream of future profits, and times it isn't.
If you buy at a time that the valuation is extreme, your money will earn nothing for a long time. Potentially a very long time.
If you're fine with that being an inevitable corollary of your advice, and your kids know it too, then all power to you and your kids.
But a bit of context is important. Never mistake a cycle for a trend and extrapolate from a stretch that was unusually good.
History is usually a good instructor.
The real total return of the S&P 500 in the first decade of this century (end date smoothed) was -1.49%/year compounded, counting dividends.
The non-financial subset was trading at about 8.3 times trailing sales at the start of that stretch.
They're currently trading at 9.9 times trailing sales. So who would rationally expect a better outcome this time around?
So, unless you think a dollar of sales at the average firm indicates WAY more aggregate future profits than it used to, the medium term outlook for returns is bleak indeed.
The future is never certain. But you should always start your planning with a set of assumptions that is self-consistent and also consistent with the known data. Pick a likely growth rate for aggregate after-inflation US market sales over the next 10 or 20 years. Pick any number you believe for likely future gross margins, and corporate tax rates, and average interest costs as percent of EBIT. That research paper has a lot of data that would let you pick plausible or optimistic numbers for all those factors. From those assumptions, you have a rough estimate of future aggregate net profits. Slap on the multiple you think is likely, and you get a future level for the index. Add the current dividend yield. What rate of total return do you end up with? Is it the one you were expecting before you did that exercise?
Over the long run, net profit margins can't rise without limit: they can't rise faster than sales, or they would exceed sales at some point. And aggregate sales can't rise faster than the size of the economy the companies are embedded in. Non-financial S&P 500 sales have risen at only inflation + 1.54%/year so far this century, so, once you look past the ultimately bounded squiggles in interest costs and tax rates, that's roughly the amount the true very long term value of the S&P 500 index has probably risen (and will likely continue to rise, give or take). Add around 2%/year in value generation for the dividends.
[That's using the non-financial subset as a proxy for the whole set of firms, which isn't too unreasonable an approximation]
The advice I give to my younger relatives: if things are going well, any index is fine. A rising tide lifts all boats. Why work harder?
But when the good times end and the odds start going very substantially against you, simply never hold any material amount of your money in something you yourself deem to be overvalued. i.e., simply don't hold anything that doesn't have a likely forward return--based on self-consistent assumptions--that is good enough to interest you.
The odds have gone substantially against us. So, either live with very low expectations for returns for a long time, or do something to improve the returns in your portfolio. Either get more selective, or try your hand at the unreasonably difficult game of timing. Personally, I keep a portfolio mainly of equities that aren't priced in a bubbly way, plus at the moment a pretty good pile of cash for opportunistically buying things on price plummets. My picks will certainly drop in the next bear market along with everything else, but, unlike the really bubbly things, their prices will come all the way back again.
I can easily refute the claim that our profits were due to "one-time falls in interest costs".
It's the long term interest cost to companies, not the current headline rate, that matters here.
What can I say? Read the paper from the Fed. I look forward to your refutation of their conclusions, with similarly strong data support.
I'm not saying that facetiously: I would love for their conclusions to be wrong.
Jim
