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Where will S&P 500 end up in 2030?


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I have decided to make a fool of myself and put together my estimates for where S&P 500 would end up in year 2030 and 2040.

 

http://vinodp.com/documents/investing/Expected%20Market%20Returns%20from%202020.pdf

 

There is nothing new to those who have followed Philosophical Economics blog. That is truly a gem and most of you would find that blog more helpful.

 

I know most of us are supposed to completely ignore the market. But I think having some idea of what the market returns are likely to be is very important. First, it sets up a baseline return that could be used as the opportunity cost when looking at any other investment. Second, it seems to me that ignoring your main "the enemy" might not be prudent.

 

The overall stock market and S&P 500 is a very good approximation, is vastly lower risk than any single company. So unless, the individual stock is offering a significantly higher return, the risk reward in the individual stock simply would not be good enough to make it into my portfolio. Hence, my attempt at understanding the expected market returns.

 

Vinod

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I did not go in depth through your calculations and assumptions yet.

With simple DCF model stolen borrowed from Brooklyn Investor, plugging in ~130 earnings, 10 years DCF, 5% growth, terminal 15 P/E, results in 10% return from 2200, 8% return from 2500, and 5% from current levels (~3180). I think that matches your numbers approximately. 8) (Yeah, I know adjust for Covid and all that.)

 

Thanks for posting.  8)

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I do this type of analysis too for the same reasons and my numbers generally agree with yours.

 

One thing I do differently is instead of truncating the investment horizon at 10-20 years I just let it go to infinity and ask what would be my IRR if I were to buy the index and hold it forever (and replace buybacks with dividends).

 

The basic formula is:

 

Real IRR = (1-g/r)*y + g

 

g = long term growth rate of real earnings

r = long term average ROE

y = normalized earnings yield

 

Using historical numbers and some educated guesses for the parameters I have an estimated range of around 3-6% (assuming the virus doesn’t result in any serious long term impairment).

 

One nice thing about this method is that you don’t really need to think about terminal valuation multiples when estimating your IRR. (They are basically implied by the fundamental parameters above.) Also interest rates don’t enter the formula. Instead you estimate your IRR first and then you compare that with bond yields and such. I think this makes the analysis conceptually cleaner and helps you avoid nonsense like “interest rates are zero/negative so therefore stocks must be worth infinity.”

 

(Of course if you know you are going to sell your stocks after 10 years or whatever this is not really the formula to be using.)

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Vinod,

 

See https://www.msci.com/documents/10199/a134c5d5-dca0-420d-875d-06adb948f578

 

GDP growth can relate to aggregate income growth, but not eps growth. The estimated impact is 2% across many markets.

 

Reasons can be raising capital for growth investments, or paying for index inclusion or IPOs of new companies.

 

Also makes sense at an individual company level. Most companies will actually grow less than GDP. That’s how agriculture and then manufacturing became smaller parts of the GDP. Very few companies will exceed GDP for longish periods.

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Vinod,

 

See https://www.msci.com/documents/10199/a134c5d5-dca0-420d-875d-06adb948f578

 

GDP growth can relate to aggregate income growth, but not eps growth. The estimated impact is 2% across many markets.

 

Reasons can be raising capital for growth investments, or paying for index inclusion or IPOs of new companies.

 

Also makes sense at an individual company level. Most companies will actually grow less than GDP. That’s how agriculture and then manufacturing became smaller parts of the GDP. Very few companies will exceed GDP for longish periods.

 

Terrific point! I have been reading Dimson, Ritter, Arnott, and Bernstein's research for a very long time.

 

Agree completely. Especially point about weak negative correlation between equity returns and GDP growth.

 

I had thought about these points but chose to skip over them and instead incorporate a somewhat weaker growth than can be justified purely from a GDP growth basis.

 

I think the best we can say about GDP growth and EPS growth is that in the long term a positive GDP growth is essential for EPS growth. But GDP growth by itself does not correlate with EPS growth for all the reasons they mention.

 

Vinod

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Vinod,

You may already be aware of the following link:

https://thereformedbroker.com/wp-content/uploads/2012/08/Explaining_Equity_Returns_GMO.pdf

Exhibit 4, which is somewhat noisy, needs an update and it's unlikely that the long-term relationship of those variables has broken down. At least, that's what Mr. Buffett implied when he closed his partnerships in the late 60s and when he wrote his 1999 market environment article.

i've book-marked this thread to have another look in 2030.

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Vinod,

You may already be aware of the following link:

https://thereformedbroker.com/wp-content/uploads/2012/08/Explaining_Equity_Returns_GMO.pdf

Exhibit 4, which is somewhat noisy, needs an update and it's unlikely that the long-term relationship of those variables has broken down. At least, that's what Mr. Buffett implied when he closed his partnerships in the late 60s and when he wrote his 1999 market environment article.

i've book-marked this thread to have another look in 2030.

 

Thanks Cigarbutt for the link.

 

I am skeptical about this relationship. Assume for example in the past, a GDP of $100 needed $50 of capital investment. In that case profits of 3% of GDP, would generate 6% return on capital. Seems like a fair return. Now assume as the economy changed, it now needs $100 of capital investment to keep up that same $100 of GDP. Then profits have to increase as a percentage of GDP to ensure that those providing capital generate adequate returns.

 

So to me it does not look like there is any fundamental economic logic to say profits need to be a certain percentage of GDP. Especially does not seem to be useful in any attempt at divining the market attractiveness. I understand Buffett's case but it always seemed to me to be one of his weaker arguments.

 

Vinod

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Also regarding EPS growth not strongly correlating with GDP growth, the major flaw with most of these arguments is poor data. There had been heavy emphasis on dividends for several decades early on in the stock market history and there has been a transition to stock buybacks from the 1990s onward. This causes several problems.

 

The link below is one article among many that explores this issue.

 

http://www.philosophicaleconomics.com/2015/03/treps/

 

Vinod

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I am skeptical about this relationship. Assume for example in the past, a GDP of $100 needed $50 of capital investment. In that case profits of 3% of GDP, would generate 6% return on capital. Seems like a fair return. Now assume as the economy changed, it now needs $100 of capital investment to keep up that same $100 of GDP. Then profits have to increase as a percentage of GDP to ensure that those providing capital generate adequate returns.

So to me it does not look like there is any fundamental economic logic to say profits need to be a certain percentage of GDP. Especially does not seem to be useful in any attempt at divining the market attractiveness. I understand Buffett's case but it always seemed to me to be one of his weaker arguments.

Vinod

Interesting.

Perhaps another way to look at this is to look at the profits to GDP using an income statement perspective. When zeroing in a specific investment and 'normalizing' the line items, i often end up with downward adjustments that make the price out of reach. Reversion to the mean may not always exist and may take a long time to revert.

Items (moving bottom to top line):

-corporate taxes: recent trends have been quite favorable (sustainable?)

-interest on debt: despite much higher debt loads, debt servicing trends have been favorable (sustainable?)

-labor compensation costs (declining share of wage income versus increasing capital share) have been on the decline for decades (globalization, automation etc), (will the pendulum come back?)

-corporate profits using GAAP have vastly underestimated (when cross-checked with NIPA profits) the true cost of stock-based compensation for the last 10 years, suggesting that share price increase has been more related to multiple expansion than real earnings as GAAP reported.

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I am skeptical about this relationship. Assume for example in the past, a GDP of $100 needed $50 of capital investment. In that case profits of 3% of GDP, would generate 6% return on capital. Seems like a fair return. Now assume as the economy changed, it now needs $100 of capital investment to keep up that same $100 of GDP. Then profits have to increase as a percentage of GDP to ensure that those providing capital generate adequate returns.

So to me it does not look like there is any fundamental economic logic to say profits need to be a certain percentage of GDP. Especially does not seem to be useful in any attempt at divining the market attractiveness. I understand Buffett's case but it always seemed to me to be one of his weaker arguments.

Vinod

Interesting.

 

A simpler way to say this is that it is ROE that should be mean reverting not profit margins or profits as a percentage of GDP. That seems to make more sense to me.

 

Perhaps another way to look at this is to look at the profits to GDP using an income statement perspective. When zeroing in a specific investment and 'normalizing' the line items, i often end up with downward adjustments that make the price out of reach. Reversion to the mean may not always exist and may take a long time to revert.

Items (moving bottom to top line):

-corporate taxes: recent trends have been quite favorable (sustainable?)

-interest on debt: despite much higher debt loads, debt servicing trends have been favorable (sustainable?)

-labor compensation costs (declining share of wage income versus increasing capital share) have been on the decline for decades (globalization, automation etc), (will the pendulum come back?)

-corporate profits using GAAP have vastly underestimated (when cross-checked with NIPA profits) the true cost of stock-based compensation for the last 10 years, suggesting that share price increase has been more related to multiple expansion than real earnings as GAAP reported.

 

This is pretty much my belief as well the better part of the last 10 years. Now, however looking at the data I am not so sure.

 

If these are really the factors, most of them should impact all or at least the majority of the companies in the US. Instead, we see that for 80% of the companies in the US profit margins are pretty much in line with their historical averages. So you are confronted with the fact that only 20% of the companies have higher profit margins compared to the past and they are concentrated in a narrow set of industries.

 

This casts doubts on the theory that labor compensation, taxes, interest costs, etc are the contributing factors for the profit margin expansion.

 

I am quite perplexed and not sure what to make of this.

 

Vinod

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One hypothesis that I know is discussed quite seriously is that several decades of lax antitrust regulations led to industry consolidation and therefore greater market power and higher profitability for major US corporations. I think it’s fair to say that there is quite a bit of resentment in the air about all this and that a major policy reversal is not at all unlikely — especially if Democrats gain enough political power in the coming years.

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One hypothesis that I know is discussed quite seriously is that several decades of lax antitrust regulations led to industry consolidation and therefore greater market power and higher profitability for major US corporations. I think it’s fair to say that there is quite a bit of resentment in the air about all this and that a major policy reversal is not at all unlikely — especially if Democrats gain enough political power in the coming years.

 

Good point. I do agree that it had an impact and does not conflict with the idea of a few firms having higher margins.

 

Grantham made the same point in a recent interview.

 

Basic mean reversion is the bedrock idea. So we studied the rate at which asset classes tended to mean revert and around which levels. So asset allocation is profoundly based on history repeating itself or following certain principles. And one principle is that if you have an abnormally high return in an industry or a company or a marketplace, it will attract more competition and drive it down to some historical normal and it should work that way. In a healthy capitalist system, if a subset of an industry starts to make 40% a year return, everyone should drop what they're doing and spend some of their energy and money copying it as faithfully and as quickly as they can. And if they do, you have a dynamic rapidly moving capitalist system. You also have one in which those returns will get bit down pretty fast and more towards be more average returns.

 

That's a healthy system. Now we've diverged away in recent years from that, last 20 years. And the degree of monopoly, particularly in the US has climbed. The degree of corporate influence of government and regulation has climbed which facilitates monopoly. The willingness of the justice department to break companies up has declined, not surprisingly under those conditions. And consequently, the returns have been above average for much longer than would have been feasible in the old days. They would have been competed down and that process has weakened. And in the short run, it's great for stock prices in the long run, it's bad for the capitalist process. It definitely shows a weakening in the competitive spirit and speed.

 

Vinod

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