S&P 500 Index funds are in for a decade from hell

Chances are this approach will continue to succeed over a period of many decades. This is even more the case for investors who value dollar cost averaging, or buy in increments over a long period of time, during market ups and downs.

But the evidence shows that it’s an absolutely terrible time to buy into the broader market, especially for investors looking to hold for about a decade.

That’s a bold statement, considering the S&P 500 is up 25% over the past year.

But that’s just it. The market has gotten so frothy in terms of valuation that it’s setting itself up for terrible returns over the next 10 or so years. At least that’s what the numbers say.

Valuations measure how expensive stocks are relative to history. One of the most common metrics is the 12-month price-to-earnings ratio, which considers the price of a stock or the overall market relative to short-term earnings expectations. There is also the price-earnings-growth (PEG) ratio, which takes into account long-term growth prospects.

But for determining long-term returns, other metrics prove to be more reliable when it comes to determining how stocks will perform over the long term.

Take the Shiller cyclically adjusted price-to-earnings ratio (CAPE), which is a 10-year average of the trailing 12-month PE ratio. This normalizes the measure by smoothing out outliers.

According to an analysis by Michael Finke, a professor of wealth management at the American College of Financial Services, the CAPE ratio has an outstanding ability to predict future returns. In 2020, Finke conducted a regression analysis, a statistical test that aims to identify the influence that several variables have on a given outcome, and found that between 1995 and 2010, the levels of the CAPE ratio at any point in time explained 90% of the S&P 500 returns over the next decade.

The relationship between the CAPE ratio and future returns bodes poorly for the next 10 years. The S&P 500’s current CAPE ratio is 35.7, behind only the 1999 and 2021 levels and above the bubble highs of 1929. A level of 35.7 puts estimated annual returns over the next decade at about 3%.

While that may not sound that bad, the benchmark index has returned 10.9% annually since 2008. Plus, the 10-year Treasury offers a risk-free annual yield of 3.89%.

When Finke released his report, John Rekenthaler, a vice president of research at Morningstar, marveled at the findings.

“Have you ever seen such a close fit between a stock market signal and future performance? If so, let me know, because I can’t think of an example,” Rekenthaler wrote in July 2020. “I believed that Finke’s work was accurate given his background, as well as the reputation of the website that published the article, but I confess I didn’t fully believe those numbers until I ran them myself.”

Enter John Hussman. Hussman, president of Hussman Investment Trust, is a so-called perennial bear who is seemingly always pessimistic about the outlook for stocks. While it may be easy to ignore these types, his data is hard to argue with.

Hussman’s preferred measure of valuation is the total market capitalization of nonfinancial stocks to the gross value added of those stocks—essentially a price-to-earnings ratio of real economy companies.

Like the CAPE ratio, it has an uncanny ability to predict where the market will go in the long term. And the more extreme the initial estimate, the better its predictive ability appears to become over the next 12 years.

As the arrow in the chart above indicates, the metric’s mid-July levels put the S&P 500’s projected annual returns at -6% over the next 12 years.

Here is the measure, which has recently hit all-time highs.

Hussman often writes that high initial valuation levels lead to “long and interesting journeys to nowhere,” which the market cycles through economic cycles over the next 12 years. For example, the S&P 500 was still lower in early 2012 than it was in early 2000, at the height of the dot-com bubble. Meanwhile, investment at post-bubble lows in 2002 would mean more than 50% growth by early 2012.

To reiterate, these gauges provide an outlook for the overall S&P 500 over a given time frame of 10 or 12 years. Ratings don’t matter as much in the short term. Here’s a Bank of America 2021 chart showing the impact initial valuations have on subsequent returns in each of the next 12 years.

For example, the levels for both of the above valuation metrics rose historically a few years ago, yet the S&P 500 is up 47% since the start of 2021.

Similarly, if you’re in your 20s or 30s and don’t plan to touch your stock market assets for decades to come, the data shows it’s not worth that much.

But based on the numbers over decades, there is little doubt that starting valuations affect future returns over the long term. And if you plan to pull your money out of the market in about 10 years, now might not be the best time to buy.