As our population ages, future stock market returns will be lower. Here’s a metric to watch

- Advertisement -


Over the past few months, the stock market index has been precariously balanced on a knife edge. Is this a harbinger of a significant correction or just a pause before the stock price starts its upward move? In the short term, no one knows. Ironically, predicting stock returns over the next 20 or so years is easy, and it doesn’t look good.

- Advertisement -

There is no doubt that the stocks have brought immense benefits to the long-term investors. As Jeremy Siegel explains in his book, stock for the long haulhandjob A dollar invested in the US stock market in 1802 would have grown to $8.8 million by 2001. Even if we exclude inflation, a dollar increase over that period would be just under $600,000.

This translates into a real return of around 7 per cent, which shows the magic of compound interest annually. In the last 30 years, the actual return has been more than 8 per cent.

advertisement

Story continues below ad

Canada’s figures almost never go back, but a dollar invested in Canadian stocks in 1924 will grow to $445 by 2019 (after adjusting for inflation). Although this sounds less impressive, it translates into an annualized real return of 6.6 percent. All returns quoted above include dividends.

- Advertisement -

Given the long history of spectacular returns, why can’t we expect this stellar performance to continue? There are two reasons for this, the first is demographics. The age distribution of the population is radically different now than at any time in the past. Despite the benefits of immigration, we are getting older, which means the proportion of senior citizens is much higher not only in Canada but globally.

An aging society is likely to lead to less economic growth, and may translate into lower income growth for companies that make the market. For example, consider Japan. Its society is 20 years ahead of us in aging, and neither its economy nor its stock market has grown beyond the 1990s. Japan’s major index, the Nikkei 225, is still lower than in 1989.

Quitting your job in great resignation? Put retirement benefits on your asking list

If Your Home Is Your Retirement Plan, Check Out the Latest News on Reverse Mortgages

Another reason why stock prices tend to rise more slowly has to do with the price-to-earnings ratio, the stock’s price divided by annual earnings per share. The P/E ratio is an indicator of how high the stock market is in general. Let’s consider the P/E for the S&P 500 Index as data is more readily available than in Canada and more detail in the past.

Historically, the P/E for the S&P 500 has fluctuated between 10 and 20 based on 12-month past earnings (see accompanying chart). Until recently, it has breached the 30 limit only twice.

The first (I consider the period from 1998 to 2001 as part of the same event) coincided with the dot-com bubble, which burst in 2001. The second occurred just before the Great Recession of 2008-09.

The P/E of the S&P 500 is once again above 30, where it has been since January 2020. In fact, it is closer to 35. I am not going to predict an imminent crash, but I would suggest that high P/E is not good for the medium term. That’s because the scenarios in which the stock can continue to perform well are far-fetched compared to the scenarios that lead to diminishing returns.

Story continues below ad

Basically, the future return on shares is determined by the change in P/E ratio. If the P/E is constant, the actual return on all stocks has averaged around 7 percent. It was so until the 1990s. When P/E is rising, real returns can be higher and since 1990, when P/E has doubled, real returns have averaged 8 percent. This is because if the P/E ratio drops significantly, the real return will also decline.

For the next 20 or so years, consider the scenario in which the P/E ratio remains in the mid-30s. If that happens, we have every reason to expect actual returns to be around 7 per cent. If the P/E rises still higher, the actual return could be as high as 7 percent. The problem is that this scenario is highly unlikely because a P/E above 30 has never been sustainable since 1900.

Now what if the P/E ratio slowly falls back to 25? This is actually quite an optimistic scenario, given that the range used to be 10 to 20. However, this will not bode well for the returns of the stock market. Assuming that nothing unusual happens in profit growth, the actual return will drop to about 5 percent.

Worse, imagine that the P/E is slipping back to 20 and profit growth declined by one percent in a year. In that case, the future 20-year return on the S&P 500 would realistically be just 3 percent per year, which isn’t much on a risk-adjusted basis.

Unfortunately, there are few viable options for investing in stocks. Bond returns will almost certainly be worse and real estate investing is fraught with its own problems. All of this suggests that anyone saving for retirement should start saving a little more. For retirees whose savings days are behind them, they should be fine as long as their investment return expectations are modest.

Frederick Waitis is the former chief scribe of Morneau Schapel (now LifeWorks) and . is the author of The Rule of 30: A Better Way to Save for Retirement, which is releasing on 19 October.

Story continues below ad

Be smart with your money. Get the latest investment insights delivered to your inbox three times a week, with the Granthshala Investor newsletter. .

.

- Advertisement -
Mail Us For  DMCA / Credit  Notice

Recent Articles

Stay on top - Get the daily news in your inbox

Related Stories