February 04, 2021
Neil Irwin had an interesting piece reporting on returns to investors who just held stock index funds over long periods of time. The point of the piece is that people who just held an index, rather than trying to speculate on individual stocks, have seen very healthy returns over the last three decades.
While the basic point is well-taken (most people will lose money by trading, both because they tend not to make the right calls on average and because of the fees associated with trading), there is an important qualification that should be made. Future returns over any long period will depend on the market’s current valuation relative to corporate earnings. This means that in periods where price-to-earnings ratios are high, we can anticipate lower future returns.
Irwin sort of notes this point when he comments that the real (inflation-adjusted) returns for someone who bought in at the peak of the 1990s stock bubble would have averaged just 5.0 percent. This point was not widely recognized at the time. Many of the great minds of the economics profession (e.g. Larry Summers and Martin Feldstein) wanted to put Social Security money in the stock market with an expectation of getting 7.0 percent real returns. (Some of us at the time tried to show why this was not possible given the stock valuations at the time.)
Even the 5.0 percent real return was only possible because of a shift in income from labor to capital during the weak labor market of the Great Recession and a large cut in corporate taxes. The Trump tax cut in 2017 effectively increased after-tax profits by 12 percent. This means, at the same price-to-earnings ratio, stock prices are 12 percent higher than would otherwise be the case, which translates into an increase in stock returns over a 20-year period of roughly 0.5 percentage points annually.
This story is relevant today since price-to-earnings ratios are again extraordinarily high. Robert Shiller’s cyclically adjusted price-to-earnings ratio is now at 33.7. This is below the peak of 45.5 hit in 2000, but still close to twice the long-term average. It is also worth noting that his cyclical adjustment, which compares current market capitalization to the prior ten years’ profits, will understate the PE in a period of slow growth relative to a period of rapid growth. From 1990 to 2000 the economy grew at an average nominal rate of 5.6 percent. By contrast, it has grown at just a 3.5 percent average nominal rate over the last decade. (Nominal GDP is the appropriate measure here since Shiller’s ratio is calculated using nominal numbers.) Adjusting for this difference in growth, the PE today would be very comparable to what it was at the peak of the 1990s stock bubble (in 2000).
This means that investors in stock indexes can expect relatively low returns going forward, especially if some or all of the corporate tax cut put in place under Donald Trump is repealed. That doesn’t mean it is necessarily bad to invest in a stock index, but the returns may not be quite what some people would expect.
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