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The S&P just hit an all-time record. Can it go higher from here?

Shawn Tully
·7 min read

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Big cap stocks just scored another triumph when the S&P 500 hit an all-time record in late afternoon trading on August 12, passing the previous high of 3386 and inspiring the Wall Street bulls to forecast more great gains ahead. (The index then pulled back slightly to close up 1.40% at 3380).

But here’s the question for serious, analytical investors: How do you handicap what you’ll reap over the next decade if you buy in today, at these newly-notched, pandemic-defying, record high prices?

What would you think if I told you that the best bet is an annual return for the S&P of 2.4%? You can be excused for not wanting to believe it. You might brand me a hopeless naysayer who’s clueless to the new market realities–– that Big Tech has raised profitability to a new plateau, that the Fed will always ride to the rescue, that trillions of cash sits on the sidelines poised to jump into stocks, or that, hey, with Treasury yields in the dumps, investors will just keep buying ’cause they have no where else to go. You’ll wonder if such a bleak forecast can possibly make sense, when you’ve heard nothing remotely this depressing from the traders and market strategists on CNBC and Fox Business who report from the trenches on every shift in momentum, technicals and sentiment, and mostly like what they see.

But you’d doubtless agree that buying a basket of big caps likely to give you 2.4% a year is a lousy investment. That’s one-sixth of the annual return of around 14% reaped over the past ten years. After all, the price of everything you pay for from cars to PCs to rent is bound rises at around 2%, and as for a building college funds for the kids and a fat nest egg for retirement, a portfolio that barely tops inflation won’t come close to delivering what you’ll need.

But if you ignore the current fog of hype and momentum, and focus on what history tells us about how fast profits normally grow, and what follows when valuations are this lofty and dividends this puny, you’ll see why 2.4% is indeed a reasonable forecast. “You can make assumptions that make that number a couple of points higher or a couple of points lower, but starting at these prices, that’s the most likely outcome,” says Chris Brightman, chief investment officer at Research Affiliates, a firm that oversees strategies for $145 billion in mutual funds and ETFs, for firms including Charles Schwab and Pimco.

Here’s how Research Affiliates, whose analysts hold strong grounding in academic finance, views the S&P’s future trajectory. Their methodology starts with the three components that determine future returns: the dividend yield, the growth in earnings, and the change, if any, in the “valuation,” or price-to-earnings multiple. As Brightman notes, if the P/E remains constant, the math dictates that the total gain will equal the dividend yield plus the growth in earnings.

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Because the S&P prices have risen much faster than earnings, the dividend yield has fallen to a current 1.9%. That’s less than half the long-term average, and well below the 2.3% level as recently as late 2015. How fast can the second driver, profit growth, wax to compensate for the slender contribution from dividends? Research Affiliates predicts that EPS will expand at just 3.3% a year. Though that’s a lot lower the the mid-single digit performance of the past three decades, it’s the norm over the past 130 years. “Profits growth is mean-reverting,” says Brightman. “When they’ve been higher than the norm for a long period, they tend to go back closer to the historic trend.”

He adds that earnings-per-share grow much more slowly than that overall profits in the economy for a basic reason. “It’s like GPD versus GDP per capita,” he says. “GDP per person grows more slowly than GDP. That’s because part of GDP growth is growth in the population.” Likewise, EPS trails overall earnings because new shares grow faster than total profits. New companies are constantly challenging the incumbents, adding to the shares that are divvying up same sales and profits. Companies reward managers with stock options that get converted into extra shares, and make dilutive acquisitions using stock. Newcomers that are still private also play a role by grabbing earnings from the entrenched publicly-traded players, restraining how fast they can lift their EPS.

Let’s add it up. A dividend yield of 1.9% plus EPS growth of 3.3% gives an annual return of 5.2%. But embedded in that forecast is an important assumption regarding our third driver, valuation. A best-case, 5.2% return mandates that today’s elevated P/E keeps hovering at the same, rarefied heights. Only then will the S&P provide that mid-single digit return.

For Brightman, it’s much more probable that the current P/E retreats over the next decade, for the same reason jack-rabbit earnings will slow: Over time, a kind of gravitational force pushes the factors governing stock market gains back towards their historic norms. At its record of 3388 hit in the afternoon of August 12, the S&P 500’s P/E stood at 30, according to the metrics used by Research Affiliates. That’s far above the 130 year benchmark in the mid-to-high teens. “We assume that the multiple will go halfway back to its long-term level, though far from all the way back,” says Brightman. Hence, Research Affiliates posits that the S&P 500’s P/E a decade from now, in mid-2030, will settle at around 25, still a high number.

That shrinking multiple will erase most of increases in EPS of 3.3% a year, leaving only tiny annual gains of around .5% in the share price. So all told, investors would reap 1.9% from dividends, and just half a point from capital gains, for a total of our 2.4%.

Brightman adds that most on Wall Street will dispute Research Affiliates’ forecast as far too downbeat, in part because profits have been expanding two to three points faster than his 3.3% a year for so many years the trajectory looks permanent. “Keep in mind,” he explains, “that we’re not predicting that earnings-per-share will go flat or fall for a long time to compensate for so many years of above average growth. But that’s happened many times before, and poses an additional danger now.”

“The share of the economic output provided to labor and capital is not a force of nature it’s a social choice,” notes Brightman. The political climate, he adds, is unusually hostile towards big profit makers, and shifting towards better rewarding workers who’ve seen their pay inch higher while corporate profits soared. “A vocal base of the Democratic Party has noticed that profits have grown much faster than the economy and especially wages, and mean to change that,” he says. What’s more, an increasingly narrow group of tech giants now account for a giant share of earnings, and they’re prime targets for the populist wing of the Republican Party. Conservative critics are blasting the likes of Amazon, Apple and Facebook for allegedly using monopoly power to bilk consumers. That bi-partisan war on profits could bode ill for returns come.

The dynamic that’s made the future look so barren is the giant, record-smashing run-up, precisely what’s now winning kudos from analysts, pundits and market strategists. Only one journey will enable today’s buyers to garner the kind of gains investors have reaped over the past few years: A steep fall in prices, in a round-trip back to near the levels where all the fun began.

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This story was originally featured on Fortune.com