Estimating Future Stock Returns

A major debate among stock analysts these days is the level of future returns that is reasonable to expect. Some argue that despite high valuations and profit margins today other factors will allow stocks to appreciate near historic average levels for the coming 10 years or so. Others argue that future returns have been pulled into the last few years, and returns must turn down to allow for long-term averages to be restored. This post takes a somewhat middle ground. It argues that future returns must be lower than in the recent past, but that the long-term average doesn’t have to be restored. Returns don’t have to decline as much as some are arguing. It is a longish post and has a fair amount of data, but it is worth reading.

The fact that profitability levels have stayed high for over 20 years now, showing little inclination to sustainably retreat, gives support to this view.  Additional support is provided by the fact that the elevated profitability levels seem to be concentrated in very specific industries and capitalization categories–technology, finance, and large cap multinational–rather than evenly distributed across the overall market.  For that reason, there’s likely to be a sustainable causal explanation for their emergence.

Now, none of this is offered to suggest that valuations and profit margins won’t retreat going forward.  My own view is that they will retreat, and are already in the process of doing so. I just don’t think that they are likely to retreat all the way back to past averages. It seems to me that to expect such an outcome, one has to completely ignore the relevant differences that exist between the modern era and prior eras.

One thing we can be reasonably sure of, however, is that if U.S. equity valuations stay where they are for the long-term, then returns will suffer by a different mechanism.  That mechanism is what I’m now going to try to quantify.