A client recently inquired about stock market valuation levels, expected and historical returns. The questions posed (as restated by me, for clarity purposes) were: (1) After the surge in valuations of U.S. technology stocks in the first six months of this year, are there currently “dangers” lurking in the stock market? (2) What are the historical returns of factor-based investment strategies? (3) What are the long-term (next 10 years) expected returns for stock and bond asset classes? Good questions! Let’s explore these topics in more detail
The Phenomenon of Mean Reversion
First off, I remind everyone that I do not profess to have a crystal ball – at least one that consistently works. And I don’t believe that others in the financial services industry have working crystal balls, either.
However, there is academic support for the proposition that current valuation levels for stock asset classes are correlated with long-term returns. In other words, when current valuation levels are high, future returns for stock asset classes over the long term (i.e., 10 years or greater) tend to be lower. And, when current valuation levels for stock asset classes are low, future returns for those stock asset classes – again, over the very long term – tend to be higher.
Reversion to the mean suggests that over time, stock prices and valuations tend to move back towards their long-term average or historical norms. Extreme price movements in the stock market are “temporary” (though they may last at times for decades). Stock asset class valuations eventually correct as market forces bring prices back in line with their historical averages. In other words, periods of overvaluation or undervaluation tend to be followed by a return to more normal levels.
As a point of emphasis, stock asset class valuations can remain above or below their historical averages for extended periods – many years, and even decades. Also, the process of reversion can be influenced by various factors such as economic growth, inflation, and other external economic events.
However, the performance of the stock markets is not perfectly reflective of economic factors. The overall performance of stock markets, as well specific stock asset classes, are also heavily influenced by investor sentiment. In other words, at times investors, collectively, push stock asset class valuation levels to heights (or lows) that are no longer rationale.
Mean reversion tends to occur more rapidly following economic “shocks.” Accordingly, mean reversion occurred more quickly – often within several years – for such events as the start of the Great Depression, the Oil Crisis of 1973, and Black Monday in 1987. At other times mean reversion occurs over much longer time periods; in fact, in one recent study of the 1900 to 2008 period for stock indexes in seventeen countries, the authors found that it took stock prices, on average, nearly 14 years to absorb half of a dramatic under-valuation or over-valuation in stock prices. And, while prevalent, mean reversion is not always certain; even within some 20-year periods mean reversion does not occur at all.
A Look at the Historical Returns of Various Indexes and Funds
Before looking into expected future long-term returns for stock asset classes, let’s explore historical returns for various asset classes.
As a review, factor-based investing involves systematically investing in broadly diversified stock mutual funds (or ETFs) containing stocks with a set of desirable characteristics. Important “factors” include the price factor (value factor), size factor (small cap factor), profitability factor, and investment factor.
However, as demonstrated in the 2010’s and early 2020’s, many factor-based investment strategies struggled to deliver excess return to investors, and the value factor struggled the most. Although value enjoyed a bounce back from September 2020 through December 2022, prior to that the value factor underperformed for almost a decade, largely due to the expanding multiples of technology and other growth companies. And, during the first half of 2023, as many growth stocks surged, value again underperformed.
The historical data for various indexes and funds is set forth below. All data presented are for the time periods ending on June 30, 2023.
| AVERAGE ANNUALIZED RETURNS FOR THE PERIOD INDICATED | |||||||||
| (ASSET CLASS) INDEX OR MUTUAL FUND | Year-To-Date Jan.-June 2023 | 1 Year (July 2022-June 2023) | 3 Years (July 2020-June 2023) | 5 Years (July 2018-June 2023) | 10 Years (July 2013-June 2023) | 15 Years (July 2008-June 2023) | 20 Years (July 2003-June 2023) | 25 Years (July 1998-June 2023) | 30 Years (July 1993-June 2023) |
| S&P 500 Growth Index | 21.25% | 18.25% | 11.80% | 13.01% | 14.49% | 12.13% | 10.77% | 7.86% | – |
| Russell 1000 Growth Index | 29.02% | 27.11% | 13.73% | 15.14% | 15.74% | 12.92% | 11.49% | 7.97% | 10.42% |
| S&P 500 Index | 16.89% | 19.59% | 14.60% | 12.31% | 12.86% | 10.88% | 10.04% | 7.61% | 10.04% |
| Russell 1000 Index | 16.68% | 19.36% | 14.09% | 11.92% | 12.64% | 10.77% | 10.13% | 7.75% | 10.06% |
| DFA US Large Company Portfolio | 16.85% | 19.47% | 14.52% | 12.23% | 12.79% | 10.85% | 10.01% | – | – |
| S&P 500 Value Index | 12.15% | 19.99% | 16.79% | 10.58% | 10.51% | 9.15% | 8.92% | 6.90% | – |
| Russell 1000 Value Index | 5.12% | 11.54% | 14.30% | 8.11% | 9.22% | 8.36% | 8.50% | 6.97% | 9.22% |
| DFA US Large Cap Value Portfolio Class I | 3.65% | 11.54% | 15.97% | 7.05% | 9.43% | 8.83% | 9.24% | 7.73% | 9.65% |
| S&P SmallCap 600 Growth Index | 7.02% | 10.62% | 11.88% | 5.22% | 10.26% | 10.12% | 10.69% | 8.89% | – |
| Russell 2000 Growth Index | 13.55% | 18.53% | 6.10% | 4.22% | 8.83% | 8.85% | 9.23% | 6.39% | 7.58% |
| S&P SmallCap 600 Index | 6.03% | 9.75% | 15.19% | 5.22% | 9.81% | 9.85% | 10.29% | 8.95% | – |
| Russell 2000 Index | 8.09% | 12.31% | 10.82% | 4.21% | 8.26% | 8.43% | 8.89% | 7.26% | 8.67% |
| DFA US Small Cap Portfolio Class I | 7.58% | 14.64% | 17.57% | 6.28% | 9.21% | 9.96% | 9.91% | 8.87% | 10.12% |
| DFA US Micro Cap Portfolio Class I | 6.62% | 13.50% | 18.72% | 5.66% | 9.26% | 9.68% | 9.62% | 9.20% | 10.78% |
| Russell 2000 Value Index | 2.50% | 6.01% | 15.43% | 3.54% | 7.29% | 7.72% | 8.29% | 7.62% | 9.30% |
| S&P SmallCap 600 Value Index | 5.06% | 8.88% | 18.43% | 4.96% | 9.19% | 9.45% | 9.79% | 8.57% | – |
| DFA US Small Cap Value Portfolio Class I | 4.45% | 15.43% | 24.56% | 6.54% | 8.65% | 9.21% | 9.92% | 9.37% | 11.14% |
| MSCI EAFE Growth Index (net div.) | 14.18% | 20.20% | 6.27% | 5.44% | 6.43% | 4.11% | 7.02% | 4.11% | 4.75% |
| MSCI EAFE Index (net div.) | 11.67% | 18.77% | 8.93% | 4.39% | 5.41% | 3.36% | 6.53% | 4.34% | 5.27% |
| MSCI EAFE Value Index (net div.) | 9.28% | 17.40% | 11.34% | 2.93% | 4.15% | 2.43% | 5.88% | 4.36% | 5.61% |
| MSCI Emerging Markets Index (net div.) | 4.89% | 1.75% | 2.32% | 0.93% | 2.95% | 1.81% | 8.17% | – | – |
| MSCI Emerging Markets Value Index (net div) | 6.53% | 4.13% | 6.27% | 1.22% | 1.99% | 1.17% | 8.14% | – | – |
Historical Returns: Comparison to Multi-Factor Funds
Multi-factor funds are a recent evolution, aside from U.S. small cap value funds. For example, in was only in the early 2010’s that Dimensional added the “profitability factor” and the “investment factor” to many of its stock funds.
The historical returns of various mutual funds from Dimensional Funds Advisors. Each of these funds employs, to various degrees, the size (small cap), price (value), profitability, investment, and momentum factors. The returns of various indexes are included for purposes of comparison.
As seen in the comparison below, despite the very substantial outperformance over the past 15 years of U.S. growth stocks (and hence the S&P 500 Index, which contains both growth and value stocks), relative to U.S. value (both large cap value, and small cap value stocks), these multi-factor funds held up well. In essence, despite the underperformance of the size and value factors, the utilization of other factors in these funds added to the fund’s average annualized returns.
| AVERAGE ANNUALIZED RETURNS FOR THE PERIOD INDICATED | |||||||||
| (ASSET CLASS) MULTI-FACTOR MUTUAL FUND OR INDEX | Year-To-Date Jan.-June 2023 | 1 Year (July 2022-June 2023) | 3 Years (July 2020-June 2023) | 5 Years (July 2018-June 2023) | 10 Years (July 2013-June 2023) | 15 Years (July 2008-June 2023) | 20 Years (July 2003-June 2023) | 25 Years (July 1998-June 2023) | 30 Years (July 1993-June 2023) |
| DFA US Core Equity 2 Portfolio Class I – holding 2,684 of the approximately 3,900 publicly-traded stocks on the major U.S. stock exchanges, this fund invests in companies of all sizes, with increased exposure to smaller capitalization (size factor), lower relative price (value factor), and higher profitability (factor) companies as compared to their representation in the U.S. Universe. | 12.44% | 18.28% | 16.31% | 10.44% | 11.32% | — | — | — | — |
| DFA US Targeted Value Portfolio Class I – holding 1,413 of the approximately 3,900 publicly-traded stocks on the major U.S. stock exchanges, this fund invests in a broad and diverse group of the readily marketable securities of U.S. small and mid cap companies that are value stocks with higher profitability. | 5.58% | 15.73% | 24.51% | 7.43% | 9.31% | 9.62% | 10.38% | — | — |
| S&P 500 Index (U.S. large cap stock index) | 16.89% | 19.59% | 14.60% | 12.31% | 12.86% | 10.88% | 10.04% | 7.61% | 10.04% |
| Russell 1000 Value Index (U.S. large cap value stock index) | 5.12% | 11.54% | 14.30% | 8.11% | 9.22% | 8.36% | 8.50% | 6.97% | 9.22% |
| Russell 2000 Value Index (U.S. small cap value stock index) | 2.50% | 6.01% | 15.43% | 3.54% | 7.29% | 7.72% | 8.29% | 7.62% | 9.30% |
The Impact of High Valuation Multiples on Historical Returns
As seen in the previous chart, U.S. large company growth stocks have outperformed many of the other asset classes over many of the time periods shown. This occurred even over the longer time periods (20 & 30 years) surveyed. But this outperformance, which is contrary to the desired impact of factor-based investing, can be explained by “multiple expansion.”
As of June 30, 2023, we have again seen a spread in valuation multiples between growth stocks and value stocks. In fact, the tremendous valuation levels seen for growth stocks has reached a level that was last seen at the height of the “tech bubble” in early 2000.
For all U.S. large company stocks, the S&P 500 Index valuation level is often measured by the “Shiller PE10 Ratio.” Professor Robert Shiller, a Nobel laureate, popularized a specific version of the cyclically-adjusted price-to-earnings ratio to help address temporary “false” signals in price-earnings ratios that can occur, such as at the start of a recession. Shiller takes the average of the last ten years of earnings, adjust them for inflation, and then divides the current index price by such adjusted earnings. This makes it so that the current price is divided by the average earnings over the latest business cycle rather than just one recent year of bad or good earnings. For the S&P 500 Index, an index of approximately 500 publicly traded large company stocks for companies based in the United States, the chart for the Shiller PE10 Ratio appears as follows, as of Friday, July 14, 2023 (close of trading):
Source: https://www.multpl.com/shiller-pe. Past performance is not a guarantee of future results.
What happened after the “tech bubble” in December 1999, when the Shiller PE Ratio reached its all-time high of 44.19? And, while past performance is never a guarantee of future performance, the early 2000’s was characterized by a sharp drop in growth stock valuation levels. During the early 2000’s value stock asset classes significantly outperformed growth stock asset classes.
Today we see that the Shiller PE10 Ratio for U.S. Large Company Stocks is again quite high, at 31.40. This is significantly above its 1870-2023 mean of 17.04. While changes in accounting standards over the past few decades suggest that a reasonable valuation level for this Shiller PE Ratio should likely fall between 20 and 25, we still see an overvaluation of U.S. large company stocks by at least 20%, and possibly by 30-40%, relative to historic norms.
Estimates of Future Expected Returns
There are many data points that can be utilized to estimate the future longer-term (10-year) returns of stocks. Many financial services firms provide such estimates. However, many of such firms’ methodologies are suspect, in my view.
One firm that provides higher-quality estimates of expected 10-year returns is Research Affiliates. According to its Asset Allocation Interactive software, as of June 30, 2023, the following estimated returns exist for various asset classes. In their modeling of future expected returns, Research Affiliates extends the often-utilized Gordon Growth Model (GGM) (with adjustments to the model as undertaken by Research Affiliates) to allow for the fact that asset yields can change over time (e.g., P/E multiples do expand and contract over time). In their projections of future expected returns, assets that are currently priced rich should be expected to return to fairer valuations in the future (i.e., negative return) and vice versa for assets currently priced cheap.
The models utilized by Research Affiliates provide a range of returns for each asset class. There exists a probability of future returns for each asset class in the chart below. For example:
| Expected Future (10-Year) Average Annualized Returns as of 6/30/2023 | |||||
| Asset Class | 95% probability of return in this amount or higher | 75% probability of return in this amount or higher | 50% probability of return in this amount or higher | 25% probability of return in this amount or higher | 5% probability of return in this amount or higher |
| U.S. Large Company Stocks – using the S&P 500 index as a representative sample of this asset class’s characteristics. | -1.4% | 2.0% | 4.3% | 6.7% | 10.0% |
These are projections only and should not be considered a guarantee of future returns. While the “expected return” of each asset class is the one with the “50% probability” shown in this chart, the actual range of returns that are possible over the next 10 years fall both below and above the ranges shown in this chart. Source of data: Research Affiliates – Asset Allocation Interactive (data as of June 30, 2023).
As seen the chart above, the expected 10-year return projection for U.S. Large Company stocks is 4.3%. But there exists a 5% probability that the average annualized returns of this asset class will fall at -1.4% or lower. And there is a 25% probability that the returns will fall at 2.0% or lower, according to Research Affiliates’ methodology.
Here are some of my key thoughts, before we proceed to look at other asset classes:
- While current valuations can be utilized to estimate future probable returns over long periods of time, there remains a great deal of uncertainty in such estimates.
- Don’t chase past returns. Simply because growth stocks had somewhat higher returns over past nearer-term time periods, does not mean that they will continue to sustain such higher returns in the future.
- Portfolio design may consider valuation levels, but only when they become extreme. However, while some adjustments can be undertaken to balance risk and return in the investment portfolio, diversification should be maintained.
- A disciplined approach, utilizing multiple asset classes within an investment portfolio, and undertaking a targeted or periodic approach to portfolio rebalancing, has historically led to superior long-term term returns (when compared to tactical asset allocation, such as shifting between asset classes based on historical returns).
Here is a more complete chart of expected future (10-year) average annualized returns from Research Affiliates (as of June 30, 2023):
| Expected Future (10-Year) Average Annualized Returns as of 6/30/2023 | |||||
| Asset Class | 95% probability of return in this amount or higher | 75% probability of return in this amount or higher | 50% probability of return in this amount or higher | 25% probability of return in this amount or higher | 5% probability of return in this amount or higher |
| U.S. Large Growth Stocks – using Russell 1000 Growth index as a representative sample of this asset class’s characteristics | -3.1% | 0.7% | 3.3% | 5.9% | 9.7% |
| U.S. Large Company Stocks – using the S&P 500 index used as sample of characteristics | -1.4% | 2.0% | 4.3% | 6.7% | 10.0% |
| U.S. Large Cap Value Stocks – Russell 1000 Value Index used as sample of characteristics | 0.9% | 4.3% | 6.7% | 9.1% | 12.5% |
| U.S. Small Cap Growth Stocks – Russell 2000 Growth index used as sample of characteristics | -3.1% | 1.6% | 4.9% | 8.2% | 12.9% |
| U.S. Small Cap Stocks – Russell 2000 index used as sample of characteristics | -0.1% | 4.3% | 7.3% | 10.4% | 14.8% |
| U.S. Small Cap Value Stocks – Russell 2000 Value index used as sample of characteristics | 1.3% | 5.6% | 8.6% | 11.7% | 16.0% |
| Foreign Developed Markets Large Cap Stocks – MSCI EAFE index used as sample of characteristics | 3.4% | 7.0% | 9.5% | 12.0% | 15.6% |
| Foreign Developed Markets Large Cap Value Stocks – MSCI EAFE Value index used as sample of characteristics | 5.2% | 9.1% | 11.7% | 14.4% | 18.2% |
| Foreign Developed Markets Small Cap Stocks – MSCI EAFE Small Cap index used as sample of characteristics | 3.3% | 7.3% | 10.1% | 12.9% | 17.0% |
| Foreign Developed Markets Small Cap Value Stocks – MSCI EAFE Small Cap Value index used as sample of characteristics | 5.5% | 9.4% | 12.1% | 14.8% | 18.7% |
| Emerging Markets – MSCI EM index used as sample of characteristics | 3.2% | 7.7% | 10.8% | 14.0% | 18.4% |
| U.S. Treasury Intermediate-Term Bonds – Bloomberg US Treasury Index used as sample of characteristics | 3.4% | 4.1% | 4.7% | 5.2% | 5.9% |
| U.S. Treasury Short-Term Bonds – Bloomberg US Treasury 1-3 Index used as sample of characteristics | 3.7% | 4.0% | 4.3% | 4.5% | 4.9% |
As seen, foreign stocks are expected to outperform U.S. stocks over the next 10 years. And value stocks are expected to outperform growth stocks.
Be aware that the asset classes shown in the above chart do not fully reflect the investment strategies utilized in the investment portfolios for many of my clients. By applying deeper tilts toward value and small cap stocks, while also employing factors such as the profitability (or quality) factor, investment factor, and the momentum factor, expected returns for the stock portion of investment portfolios designed by Scholar Financial, LLC can generally be forecasted to be higher – in relation to the utilization of single-factor investment strategies or a total stock market index fund.
Some Caution is Due, As Economies Continue to Evolve
Over the past 30 years, U.S. stocks have performed well, with an average annualized return falling generally between 9% and 11%. But, as discussed previously, some of those returns have been attributed to multiple expansion, particularly among growth stocks. Headwinds for stock returns over the next 10 years exist:
- According to a recent white paper from Michael Smolyansky of the Federal Reserve, the long-term trend toward lower interest rates, as well as the decline in corporate tax rates, provided a strong additional tailwind for the returns provided by U.S. publicly traded stocks over the past few decades. Higher corporate tax rates are anticipated in future years, given the size of the federal debt, which may generate some headwinds for stock returns.
- While most economists anticipate interest rates to fall modestly over the next 10 years, inflationary pressures may arise due to a decline in the size of the working-age population (globally) and the resulting demand for labor outpacing its supply. If labor costs escalate, this could put a dampening effect on corporate profits, which would in turn negatively affect stock returns.
- Long-term demographic trends (especially in Europe, Japan, and China) foreshadow a reduced labor force with likely economic contractions resulting. Whether this will be offset by the ever-increasing deployment of technology (including robotics in manufacturing, and AI) is yet to be fully determined. While U.S. working-age population growth will be far less than that seen prior to 2007, it will likely remain positive.
- Increased debt burdens among both governments and individuals will tend to also restrain economic growth. Even if debt levels stay static, relative to the size of the economies, the lack of additional credit would deter some economic growth from occurring.
I do not believe these (and other) economic circumstances have been fully considered in the projections done by Research Affiliates (as well as those undertaken by many other financial services firms). Nor do these projections include the possibility, however remote, of another major economic shock – such as one that might occur due to a more widespread war, another Great Depression, or another Great Recession.
Yet, despite these potential headwinds, new developments may well occur that promote economic well-being and propel economic growth. For example:
- With the rise of renewable energy deployments, especially solar and wind, the long-term levelized cost of energy will be capped. Further increases in solar cell efficiency will occur, which will likely accelerate the deployment of solar panels. While in the short-term oil and natural gas prices will remain volatile, the decline in demand for carbon fuels bodes well for the future.
- Electric vehicles (EVs) will likely cost less to produce, and last longer, than vehicles with internal combustion engines. Both the costs of electric motors, and batteries, for EVs will likely decline over the next 7 years. Given that the annual cost of the average consumer vehicle in the U.S. now exceeds $10,000, any decline in the cost of car ownership is welcome.
- Robotics continues to bring down the cost of manufacturing certain goods. Recent U.S. government tax policies have further encouraged the return of manufacturing jobs back to the United States (from China and certain other countries).
- The pain felt by many fixed income investors over the past 15 years, in a era of historically low interest rates, and the additional pain felt as interest rates rose at an unprecedented pace since early 2022, will likely subside. Higher yields means that fixed income investments will tend to contribute better to the overall returns of an investment portfolio.
In Conclusion
Fear and greed are powerful motivators. And many financial advisors and their firms prey upon these emotions, often touting that they possess the means to “navigate” the ups and downs of stock market investing through well-timed market timing decisions. I have seen no significant evidence that market-timing strategies work to aid in returns. In fact, the academic evidence supports the conclusion that strategic asset allocation (as employed by Scholar Financial, LLC) is far more likely to lead to successful long-term outcomes.
A disciplined approach, informed by the academic evidence into “what works” and “what does not work” in the field of investments, should be observed and followed.
There are some keys to investment success I believe in:
- Use multi-factor investing to possess a high probability of superior equity (stock fund) returns over the very long-term.
- Use high-quality fixed income investments, typically of short-term or intermediate-term duration, to provide stability to the investment portfolio.
- As you approach and/or enter retirement, possess a relatively balanced portfolio between equity and fixed income investments. Visualize your portfolio as a “three-layer cake,” in which the top layer is intended for consumption (spending) for the next five years. The middle layer is intended for consumption for the period 6-10 years from today. And the bottom layer (equities, typically) is for utilization more than 10 years from today.
- Buy low, sell high, through a disciplined approach to portfolio rebalancing.
- Keep investment fees and costs reasonable. Mutual funds and ETFs provide diversification benefits, but careful selection is necessary to ensure both their disclosed and “hidden” (transaction and opportunity) costs are relatively low.
- Design the manage the investment portfolio with a view toward greater long-term tax efficiency.
If you possess any questions about your investment strategy or your investment portfolio, please give me a call.
Thank you. – Ron
Dr. Ron A. Rhoades serves as Associate Professor of Finance and Director of the Personal Financial Planning Program within the Gordon Ford College of Business at Western Kentucky University. He teaches and has taught courses in Retirement Planning, Applied Investments, Advanced Investments, Estate Planning, Financial Plan Development, Personal Finance, Money & Banking, Risk Management and Insurance, and Principles of Finance. He is regarded as a national expert in the application of fiduciary duties to the delivery of investment and financial planning advice. Ron’s upcoming book, Mastering the Science and Art of Investing: Strategies for Maximizing Returns with Multi-Factor Portfolios, is due to be published later in 2023. Ron is also the author of Professor Money Bear’s Guide to Personal Finance, a textbook he provides free of charge to students in Western Kentucky University’s Personal Finance classes.Dr. Rhoades’s financial planning and investment advisory firm, Scholar Financial, LLC, is now accepting new clients. Dr. Rhoades prefers to work with those individuals and couples with greater than $1m in financial assets who are approaching retirement or who are in retirement, and with executives. See this web site “For Prospective Clients” to learn more.