US stock market performance was exceptionally strong in the last decade. For the ten-year period ending June 30, 2023, the S&P 500 index returned 235% which is almost 12.9% per year. This is well beyond the long run average annual return of about 10% since 1926 and much higher than the 5.1% annual returns in the preceding decade. Interestingly, US corporate profit growth was much stronger from 2003-2013 (when US stock returns were lower) than in the most recent decade. This raises an interesting question: if not driven by profit growth, what were some of the other factors that may have influenced stock returns in the last decade?
A new Federal Reserve Board research paper by Michael Smolyansky offers one perspective by outlining some of the unique factors that may have contributed to returns in recent years. Many of the catalysts he proposes sound reasonable enough (lower tax rates, lower interest rates, higher valuations). But after listing these factors, the author then jumps to the conclusion that the era of high US stock returns is ending, and that investors should temper their expectations for future returns from here.
Mr. Smolyansky’s argument is this: recent US stock returns were boosted by a set of unique conditions that are unlikely to be repeated in the future. These conditions are (1) a major reduction in the US corporate tax rate, (2) a general decline in interest rates (leading to lower interest expenses), and (3) rising valuations, driven largely by the same decline in interest rates over this period. And because both tax rates and interest rates are unlikely to go much lower from here, equity returns are destined to be significantly lower in the next few decades.
Will US stock returns be much lower from here? No one knows for sure, but given the paper’s assumptions, the anticipated outcome is entirely possible. Higher interest rates and higher taxes would very likely impact corporate earnings in a negative way, curbing profit growth and thus reducing future returns on US equities. However, we simply don’t know if the paper’s assumptions will hold true over the next 10 or 20 years. For example, long-term interest rates in the United States are around 4% today. In Japan, they are less than 1/2%. Interest rates could still fall substantially from here, lowering discount rates and helping returns.
We also can’t predict future GDP growth with any accuracy – growth rates could slow from here, or perhaps there will be a boom driven by artificial intelligence, or the invention of a cheap and bountiful source of energy will drive economic growth much higher than expected. The point is that the future is uncertain and investors need to be prepared for a wide range of potential outcomes.
We won’t know for a long time if Mr. Smolyansky’s predictions come true, but his paper does serve as a good reminder of the importance of planning because a world with lower returns is a real possibility. A financial plan that requires 13% annual returns, like those experienced in the last decade, to succeed is just not a solid plan. But neither is one that totally relies on the performance of single country to drive returns, even if that country is the United States. Instead, a plan that is built around a low-cost, highly diversified global portfolio is more likely to lead to overall success and a better investment experience.