Unconventional wisdom: Troubling environment for returns predicted
Are lower returns a mathematical certainty?
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Troubling environment for returns predicted
“The difference between the poet and the mathematician is that the poet tries to get his head into the heavens while the mathematician tries to get the heavens into his head.”
― G.K. Chesterton
The first step I take when researching any new investment opportunity is a back of the envelope assessment of the sources of potential returns.
The fundamental truth of investing is that returns only come from three places – dividends, changes in valuation and earnings growth. Reminding myself of these three sources of returns is a good way to cut through the noise.
Having this grounding before doing additional research is helpful because it can direct my efforts in assessing the potential of an investment opportunity. It is also a great method for quickly eliminating prospective investments.
Looking at local standout CBA is illustrative of the process. Over the past five years CBA shares have returned 17.07% per annum while earnings have only increased by 2.92%. Clearly the catalyst of the strong returns has been valuation changes and the dividend.
CBA’s price to earnings (P/E) increased from 17.46 at the end of 2019 to the current level of 25.20. The dividend yield of 5.39% at the end of 2019 also helped.
To buy CBA today would require faith in valuation levels continuing to increase and / or an acceleration of earning growth. The dividend will play less of a role going forward as CBA now yields 3.19%.
If I was considering buying CBA I could focus my research on the likelihood of these scenarios playing out.
I think this is a helpful way of framing my personal research. And given how much I like this approach I was naturally drawn to a recent study that used the same technique to assess the prospects for the overall market.
Scenario analysis of the share market
Finance Professor Javier Estrada at IESE Business School recently published Expected Returns in Bullish Times which applies the same technique of exploring the underlying drivers of returns. The results don’t look pretty.
Professor Estrada used one of the best datasets available from Professor Robert Shiller at Yale as the basis for the paper. Shiller’s data is updated monthly and has historic valuation levels, returns and dividends for the S&P 500 from 1871.
The first thing Professor Estrada calculated was the correlation between earnings growth and rising valuation levels. This represents the ideal scenario for investors. Earnings growth and investors willing to pay more for those earnings can turbo charge returns. Despite relatively modest earnings growth this combination served CBA shareholders well.
Professor Estrada’s work showed this ideal situation rarely occurs. He calculated the correlation between earnings growth and changes in P/E for several rolling periods between 1871 and 2024 for the S&P 500. The results can be found in the following chart.
Source: Expected Returns in Bullish Times
Over each period the correlation between earnings growth and changes in P/E are negative. This means the two variables move inversely. During periods of earnings growth valuation levels contract and vice versa.
At first glance this seems counterintuitive. Valuation levels are fueled by investor optimism which you would expect during periods of high earnings growth. However, the market is forward looking and it is too late to profit if you wait for something to occur. Investors anticipate future trends and react accordingly.
The global financial crisis (“GFC”) is illustrative. Earnings for the S&P 500 reached $84.92 in June 2007. By March 2009 they were down to $6.86. The P/E ratio rose over that period from 17.83 to 110.37. Even as earnings plummeted the market did not get cheaper on a price to earnings perspective although prices fell significantly.
In the depths of a severe recession investors anticipated a recovery in earnings and the market started going up. When earnings did recover to $77.35 by the end of 2010 the P/E ratio dropped to 16.05.
Where to from here?
After providing the context of historical correlations between earnings growth and valuation levels, Professor Estrada turned his attention to where we stand today. In June of 2025 the S&P 500 was trading at P/E ratio of 27 and a dividend yield of 1.30%.
Given the current dividend yield the following chart shows different scenarios for changes in valuation levels (x-axis) and earnings growth (y-axis) and the resulting annual return over the next decade.
Source: Expected Returns in Bullish Times
If the S&P 500 traded at a P/E of 30 and earnings grew 1% annually for the next 10 years investors would get a 3.440% annual return over that period.
In his paper, Professor Estrada argued that looking at historical averages suggests that returns will drop from what we’ve recently experienced.
To approximate the 13.20% annual return for the S&P 500 over the last decade means earnings growth of 9 to 10% annually with a P/E of 30 or 35. Given the historical average P/E of 16 and earnings growth of 4.20% between 1871 and 2024 this scenario appears unlikely.
My view of the findings
I have two concerns with Professor Estrada’s approach. The first is his reliance on data going back to 1871 to draw conclusions. Since 1871 the types of companies in the S&P 500 have changed significantly, accounting has been standardized, and data quality has increased. In theory I’m supportive of using the most comprehensive data set available but in this case I think a narrower range provides better context.
The average monthly P/E since 2000 is 25.74. Going back to 1990 the average is 24.58. This makes it more plausible that valuation levels remain steady. That still doesn’t mean a repeat of recent returns. Consistent valuation levels and an earnings growth rate of 4.20% would lead to annual returns of a little more than 5% over the next decade.
My other concern is with using monthly P/E as a basis for drawing conclusions. P/E ratios bounce around significantly as recessions and recoveries occur. That is why you get a P/E of 110 in the midst of a severe recession like the GFC.
Professor Shiller’s dataset uses the cyclically adjusted price to earnings ratio (“CAPE”) instead to smooth out the volatility of earnings. The CAPE takes a 10-year average of inflation-adjusted earnings instead of point in time measurements.
Using the CAPE and more recent average levels makes the market look even more overvalued. The current CAPE is 40.01 with an average of 27.71 since 2000 and 27.04 since 1990. For reference the average is 17.67 going back to 1871.
Lessons for investors
We are conditioned to view successful investors as people that are constantly doing things. We are innately driven by an action bias. But the purpose of this exploration of Professor Estrada’s work is not a call to action. It is a call to think about potential scenarios and how it may impact your finances.
It is foolhardy to expect returns to reset to a higher level on a permanent basis. ‘This time is different’ thinking has continually gotten investors in trouble. Periods of above average returns must be followed by periods of below average returns.
This can happen quickly with a meaningful drop in markets or slowly through lower returns over a longer period. Whatever happens there are lessons for investors trying to navigate the current market environment.
This is hard
I know some readers’ heads may be spinning. I’ve questioned the original study by adding caveats about P/E levels over different time periods and the use of monthly observed P/Es instead of a cyclically adjusted P/E. The obvious conclusion to draw from each adjustment is contradictory.
Many people don’t want to think. Instead they would rather have a definitive conclusion and straightforward message like Professor Estrada provided – the market is shockingly expensive and we are in trouble. If life and investing were easy we would all be thin, happy and rich.
Investing is hard. The past looks clear because we know how it turned out. The present is messy and the future is unknown.
Appreciating how hard investing is should not be discouraging. Instead, it should be a reminder to focus on the thing you can control – putting a personalized plan and strategy into place and focusing on your own behaviour.
Focus on your goals and not index returns
I understand why investors focus on index returns. The media is fixated on how different indexes are performing over increasingly short periods. Much of this focus is irrelevant to what people are trying to accomplish.
When I first started investing I created a spreadsheet and tracked my performance against the S&P 500 on a monthly basis. Given the market environment in the early 2000s it was gratifying to consistently outperform a market cap weighted index in the midst of the lost decade when the average S&P 500 share did decently.
I gradually realised that going through this exercise was doing little to help me achieve my goals. My goal was generating passive income and how the S&P 500 performed over short time periods was irrelevant. My portfolio – by design – was very different than the S&P 500. Comparing my results with the index didn’t make sense.
This is just one example of why index returns may not be aligned with your goals. There are plenty of others. Perhaps your portfolio has more local shares than the 2% allocated to Australia in global indexes. Perhaps you hold too many global shares to make comparisons with the ASX 200.
Your asset allocation may include fixed interest or cash. You could have a goal of lower volatility, a focus on capital preservation or a desire to minimise taxes from holdings that have significantly appreciated.
Focusing on things that don’t relate to what you are trying to accomplish is more likely to hurt you than help you. Think through the ramifications of lower returns for a market-cap weighted index on your own situation. It may matter or it may not.
Be mindful of the wealth effect
The wealth effect is the tendency for our spending to increase when the value of assets we hold increases. This can happen even if that increase is temporary and has no impact on day-to-day life.
Credit card giant Visa studies the wealth effect. They found in 2022 that for every dollar increase in the value of assets people spend 34 more cents. That increased spending comes from a combination of decreased saving and taking on more debt.
High returns can make investors forget that a key lever for building wealth is savings. If you are retired the key is managing your spending. Those decisions are the cornerstone of any long-term plan. This might be a time to revisit your savings / spending plan.
Final thoughts
We all want the strong recent returns of the share market to continue. However, it pays to be realistic and consider how different scenarios would impact your ability to achieve your goals.
It is also worthwhile to consider the drivers of returns. We tend to mentally bank what has happened in the past and assume it will continue without contemplating why the market performed the way it did.
Professor Estrada focused on the S&P 500. Next week I will run through a similar exercise with the Australian market.
In the meantime I’ve created a spreadsheet which lists every Aussie and NZ share in our coverage universe. This spreadsheet can be used to explore returns over the next decade based on earnings growth and P/E changes.
Email me and I will send it along – for those that have read Invest Your Way I would appreciate it if you could put a review and rating on Amazon, Goodreads or Booktopia in exchange for the spreadsheet.
Email me at [email protected].
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Invest Your Way is a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.
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What I’ve been eating
Ceviche is the national dish of Peru. Guinea Pigs are also a delicacy in Peru. I will leave it to readers to determine if correlation equals causation in this particular situation. Ceviche is simply ‘cooking’ fish in citrus. Hard to beat that.
Manly Wharf has been taken over by Felons. This is not an outbreak of crime but instead the expansion of Brisbane’s Felons Brewing Company. This tuna ceviche was from the newly opened Felons Seafood which I visited last week. It is pricey but good and you can’t beat the setting.
