Bank of America’s Savita Subramanian has been calling for weaker returns for the last few months, however she made a bold prediction recently claiming the stock returns may well be zero for the next decade.

Her argument is simply due to valuation. Right now the MSCI USA index has a P/E of 25.92 as of September end. The historical average P/E of the S&P 500 is 15.86. What this means is that the P/E is sitting somewhere at 60% above it’s historical average. The S&P 500 climbed even higher over October and its P/E now sits at 29.3, a level not seen since the dot com bubble. Of course the MSCI index is not directly comparable to the S&P 500 but they are close proxies. I will come back to why I used the MSCI index in more detail below but it helps to put that figure in perspective in why Bank of America would have such a dour prediction of returns for the next 4 years.

In their analysis, Bank of America’s equity strategist focused on 3 sectors it thought could do well over the next decade despite their prediction for weak returns overall. Those sectors were energy, financials and materials. Each of these sectors had been in a bit of a slump for their own reasons over the last decade while the tech and IT sector boomed. Their claim is that due to the large relative dividends and stable payouts, these companies will be able to continue to earn their shareholders a decent return in the interim.

For those that believe their argument for low growth, it’s easy to forget that we as investors as well as the media all have biases in the way we look at the investing world. The US equity valuation versus the rest of the world has boomed in the past decade and taken up an ever larger share of the global index as measured by the MSCI all world index which invests in the largest capitalization stocks from all over the world. Many US investors, seeing the weaker returns in other parts of the globe, may have left international investing behind. Indeed, it has been a tough decade to be in markets outside the US and many have been disappointed waiting for the market to turn outwards from the US.

Where the Value is

Despite the hype about crypto and tech returns, old stalwarts are increasingly showing some competitive returns. As I have pointed out on Twitter, PNC Bank has returns this year of 45% that are competitive with Tesla stock. Exxon Mobile and Bank of America have trounced the returns of Google and Apple over the past year, so why are few paying attention to this space and how will it shape things going forward?

The fact of the matter is that the crowd dictates returns sometimes. It’s like a self fulfilling prophecy: many predict higher returns and bid prices up, others see prices go up and they don’t want to miss out, so they enter and bid prices up as well. As long as there is someone else left to buy, the circle continues until someone finally says enough.

They say it takes 10 years for the perception of a car brand to change and for equity sectors it may be a bit faster but not much. When big returns first start to appear, many may think it’s a fluke and continue to invest in the hot sector. But if the fluke turns out to be sustainable and profits continue to roll in, the sentiment can start to shift. This is what Bank of America in their sector calls may be looking at. Investors will start to turn away from P/E ratios of 29 in the S&P 500 or even 35 for the Nasdaq 100 and start to look at more reasonably priced stocks also known as value stocks. The sectors that dominate value right now are exactly in those sectors mentioned by Bank of America: energy, financial and materials.

It’s one thing to say this but it’s another thing to see it in action. So to see how much valuations of the stock market have changed, it helps to go back 10 years ago and see what prices were then and if they have changed dramatically.

Thanks to the publicly available information from Yale economist Robert Shiller, we can easily look back on historical S&P 500 data to get a better sense of where we are in terms of valuation. I picked the end of 2020 and compared that to the end of 2010 and made some interesting observations:

• Dividends paid in 2010 vs 2020: $22.73 vs $58.28 a 9.87% increase annually over 10 years;
• Earnings in 2010 vs 2020: $77.35 vs $94.13 a 1.98% increase annually. When earnings normalized more in 2021 the annual growth evened out to about 7.45% growth annually;
• P/E in 2010 vs 2020: 16.05 vs 29.26 a 9.36% return annually.

Total annual returns over this period with reinvested dividends in the S&P 500 were 13.75% but around half of this came from the valuation changing. Today the S&P 500 sits at 4,605 but if it were trading at the same valuation as in 2010 it would be trading at 2,523. In other words, the valuation today is 82.5% higher than it was in 2010. You could make the argument that innovation has changed, new companies like Tesla have shown up and upended entire industries.

However there is a counter argument to this that just follows valuations which is the point many market strategists are now trying to make. Companies are created and destroyed all the time in the market, or at least experience ups and downs. There is always innovation in some form that the market is rewarding through profits and higher share prices. That could be through a more efficient logistics process to get cheap goods to the domestic market or it could be through a totally new service or invention. None of this means there is necessarily more innovation now than there was at any point in time but the sentiment is wildly different than it was in 2010.

In a recent blog post by A Wealth of Common Sense the author looked back at a Gallup poll which asked investors what they were investing in for the next 10 years. The overwhelming answer was gold. If we look back on recent performance, it’s easy to see why. Gold had outperformed other asset classes over the years 2001 to 2011 by about 300%. Memories were still fresh from the global financial crisis which wiped out returns on stocks as well as the housing crash, which wiped out returns on residential housing. Only gold seemed like a reasonable investment after all these market catastrophes.

Yet if you look at the subsequent 10 years from 2011 to 2021, the opposite happened. Stocks roared back as did housing, gold went nowhere. This is a bit of a simplistic example as it focused on the US, international shares didn’t exactly roar back and emerging market shares have been in the doldrums for a decade. From a US point of view however, the losers of the last decade turned into the winners of the next. If history is any guide, we would likely conclude that the high historical valuations of the stock market back up the conclusions from Bank of America’s strategists.

So What to Do?

This doesn’t mean sell tech and go all in on value and emerging markets. There is still momentum to be had in many tech sectors. I myself hold a Nasdaq 100 index which has still done well compared to small cap value and emerging markets this year.

Investors should however be conscious that there is a bubble in stocks, housing and even bonds. Given this reality it is only a matter of time before the big money starts to shift more aggressively towards the more fairly valued shares which are in those sectors I mentioned previously but as well as in international markets. Below are the different geographical P/E’s from MSCI including the ex US index, the global index and emerging markets (EM) as of September 30:

MSCI ex US PE – 18.31

MSCI World PE – 22.85

MSCI USA PE – 25.92

MSCI EM PE – 15.07

It’s worth keeping in mind that this was at the end of a small pullback in shares for the month as well, which means that US shares are even more richly valued now than before as I pointed out above.

The moral of the story is that investors need to be in sectors with more room to run when growth potentially gets more uncertain and choppy in the coming years. Gains in tech are great, but there is always more on the horizon.

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