CAPEd Crusader: Updated 10-Year Returns
Asset allocation is the biggest driver of your long-term returns. But the process requires estimates of returns and risks for the asset classes that you can invest in. For most Canadian portfolios, the largest asset class holdings are usually U.S. and Canadian equities. In my continual crusade to have the optimal asset allocation I have updated the estimated annualized 10-year returns for U.S. and Canadian stocks using the methodology from my November 2021 blog Stock Return CAPEr: The Next Decade’s Returns. Let’s see how the expected returns have changed with the sell-off in stocks over the last year.
The Geeky Stuff
I will give you a short review of the process and spare you the details of the methodology in this update. If you want to geek out, you can get more information from the November 2021 blog.
The price earnings ratio (P/E) is calculated by dividing the share price of a company or the level of a stock index by its earnings per share (EPS). EPS is essentially net income over the last 12 months divided by the number of shares outstanding. A higher-than-average P/E is one way of estimating that a stock or index is priced above fair value. On the flip side, a lower-than-average P/E indicates the price may be below fair value. The level of P/E’s are inversely related to interest rates. Higher rates tend to result in lower P/E’s (what we have seen over the last year) and lower rates tend to lead to higher P/Es.
The methodology I used is based on the CAPE (cyclically adjusted price-to-earnings) ratio, popularized by Professor Robert Shiller. The data used is the same as outlined in the previous blog, updated to January 31, 2023.
Looking South Through The Mist
Chart 1 is the same as in the previous blog, with the addition of the orange dot plotting the current data as of January 31, 2023. The chart shows, for each monthly S&P 500 CAPE ratio, the resulting annualized 10-year return for the S&P 500 (blue diamonds). The estimated 10-year returns for each monthly CAPE ratio (black squares) is based on a regression of the historical returns and CAPE ratios.
In the previous blog the CAPE for the S&P 500 was 37. This resulted in an estimated annualized 10-year return of 2% with a range of -2% to +5%. With the fall in the stock market, as of January 31, 2023 the orange dot in Chart 1 shows the CAPE declined to 29. At this lower level the estimated annualized 10-year return has improved significantly to 6% with a range of 3% to 9%.
Chart 1
Looking North Through The Mist
Chart 2 below is from the previous blog as well. It is updated with the current data as of January 31, 2023 (orange dot). The red diamonds show the subsequent 10-year returns for each monthly S&P/TSX CAPE level. The black squares are the estimated 10-year returns from a regression of the historical returns and CAPEs.
The previous estimated annualized 10-year return for the S&P/TSX, based on its CAPE of 24, was 7% with a range of 4% to 11%. The current CAPE has declined to just below 22. As a result, the annualized 10-year return is estimated at 8%, with a range of 5% to 12%.
Chart 2
Bear Market Pain To 10-Year Gain
The bad news is that most stocks have declined since I wrote the blog in late 2021. The good news is that with the lower levels of the CAPEs the expected returns from the CAPE methodology have increased. Since the U.S. CAPE has declined more than the Canadian CAPE it has resulted in a much bigger increase in the expected annualized 10-year return for the S&P 500, from 2% to 6%. However, this is still lower than the updated expected annualized 10-year return of 8% for Canadian stocks, which is up modestly from the previous estimate of 7%.
If these estimates come to fruition, over the next 10 years you could recover your losses from the last year, add some gains, and make decent returns on any new money being allocated to equities. But remember, to realize those gains you need to be a patient, long term investor as equity values never go up in a straight line!
Invest Wisely,
Dave Schaffner, CFA
Principal, Wayfairer Capital Management Ltd.