Insights

In our previous article, we highlighted the mean-reverting nature of investment returns from equities. The data showed that periods of high realised 12-year returns lead to poor outcomes and vice versa. However, note that this is just one of the conditions. It is not a sufficient enough condition to assign a high probability to poor expected investment outcomes. The key is to understand the source of “investment” returns.

Two factors affect the overall investment returns—one, underlying returns on capital of the businesses, and two, changes in valuation multiples.

The return on equity of American businesses has averaged at 11.5% over the past sixty-five years. These returns have been highly sticky around the 12% mark. The return from this component is affected by the price being paid. The higher the price, the lower the returns. We estimate this component to provide a nominal annual return of 7% from US equities at current prices. Geek’s note – the investors can earn this return only if valuations stay permanently elevated near current levels. Note that this return is before any trading costs and withholding and capital gains taxes.

The second component, valuation multiple assigned to corporate cash flows, tends to have high variability. The variability is primarily a matter of investor sentiment, the willingness or the lack of it, to pay for those cash flows. The first chart below shows the ratio of non-financial corporate market capitalisation to domestic and foreign value-added. We are currently experiencing a period of investor euphoria, which has driven valuations to extreme territories. The second chart shows the expected and subsequently realised 12-year returns. The current expected returns of US equities are their worst levels of the past seven decades.

Over the past seven decades, when this ratio has been above +1SD level, the subsequent 12-year nominal annual returns were 1.6%. Currently, we are well above +2SD levels.

We are clearly not certain about the future investment outcomes. However, we are pretty darn sure that investors will earn a poor investment return over the next 12 years from US equities.