The Long Run

“The long run is a misleading guide to current affairs. In the long run we are all dead.”

– John Maynard Keynes

“I am an optimist. It does not seem much use being anything else.”

– Winston Churchill

The S&P 500 produced a robust return of 25% in 2024, building on the impressive 26% return in 2023. The past two years have seen the best consecutive annual returns of the S&P 500 since 1997 and 1998. Returns have been driven by the largest stocks in the index and investor excitement surrounding an expected artificial intelligence (AI) fueled technology renaissance. Optimism has been further supported by resilient GDP growth in the United States and hopes that the incoming administration will support a continued expansion with a relaxed regulatory profile and favorable tax policies.

This positive momentum is tempered by concerns about the expensive valuation on the market, the concentration of market capitalization in the index among the largest stocks, and the possibility that the AI revolution will play out more slowly than hoped. Some see a parallel between the current AI excitement and the internet frenzy of the late 1990s that led to the dot-com bubble that popped in 2000. The fact that the past two years are the best since 1997 & 1998 has only reinforced that potential fear.

The main difference between our current technology fueled stock market run and the dot-com era is that the current tech leaders (Apple, Microsoft, Meta, Alphabet, and Nvidia specifically) are extremely profitable companies that generate significant free cash flow and have strong margins. While their ability to generate strong net income is reflected in their lofty multiples, their above average profitability makes them firms that should trade at a premium to the average stock.

This valuation and concentration issue is particularly relevant as we attempt to evaluate what future returns for the broad index will be over the next cycle and how that impacts both our asset allocations and return expectations for a diversified portfolio. Long run return models that estimate future returns are not crystal balls, but they can provide investors a framework to consider while reallocating portfolios and determining where additional capital can be invested to achieve the best possible future results.

Recent Market Activity 

2024 saw many of the trends that have dominated capital markets the past few years continue to build momentum. US equity markets outperformed the rest of the world, growth outperformed value, and fixed income struggled. US exceptionalism was further enhanced by surprisingly strong domestic GDP growth enabled by significant government spending and a robust consumer.

European markets faced headwinds in their manufacturing sector, especially autos, and sluggish consumer spending. China has reported growth at their mandated 5% target, but many private observers question that figure given continued fallout from the bursting of their real estate bubble.

Equity markets outside of the US do not have our mega-cap tech exposure and are more exposed to value sectors such as financials, energy, healthcare, and industrials that do not have the same revenue growth or profit margin potential as our largest firms. Also, strong growth and fewer Federal Reserve rate cuts have made the dollar an attractive currency and its strength reduces international returns for a US based investor when returns are translated back into US dollars.

One of the most unique features of the current US equity market is the large index weighting that the ten largest stocks currently enjoy. As of year-end the top ten companies made up over 38% of the index while accounting for over 28% of total index earnings per share. Those top firms, dominated by the “magnificent 7” AI beneficiaries, trade at a forward P/E of 29.8x while the other 490 companies trade at a much more reasonable 18.2x. While those large firms deserve to trade at a premium after growing earnings by over 30% the past two years while the rest of the market experienced little growth, they are now priced for perfection. The equal weighted S&P 500 and the value index both trade at more realistic valuations, and analysts predict that the earnings growth of the “other 493” companies will start to catch up to the earnings growth of the “mag 7” over the next few years. It will be crucial that they do.

Equity returns are driven by a combination of dividend yield, earnings growth, and changes in the multiple that investors are willing to pay on earnings. Last year’s 24.9% return consisted of a 1.3% dividend yield, 8.1% earnings growth, and a 15.5% increase in the multiple. In general, returns driven by dividends and earnings growth tend to be more enduring while those driven by multiples tend to fluctuate in-line with investor confidence. Unfortunately, there is no bright-line definition of what earnings multiple is too high. Forward multiples have been elevated for years, and valuation alone is not a tool that can be used to time the market. However, higher multiples imply elevated growth expectations that can be increasingly difficult to meet, and this is a useful data point to keep in mind when considering where to invest new capital or where to trim as portfolios are rebalanced.

Fixed income markets posted a modest return last year as long-term interest rates rose, but that negative impact was cushioned by tighter spreads and higher coupon rates. The ten-year US Treasury bond started 2024 at a 3.88% yield and closed the year at 4.57%. These higher yields were driven by a combination of fewer Fed rate cuts than expected, strong GDP growth, and stubborn inflation readings. Yields have continued to move higher the first few weeks of 2025 as investors digest the news of a pause in rate cuts announced at the first Fed meeting of the year, ongoing elevated inflation, and economic policy announcements from the new administration. Equities dominated financial headlines the past two years, but higher fixed income yields and their impact on the economy and markets may steal the show this year.

The tension between higher interest rates and extended multiples on the equity market matters because investors may eventually find future bond returns more attractive than those available from stocks. The easiest way to visualize this tradeoff is to compare the earnings yield on the S&P 500 (the inverse of the forward P/E) to the current yield on the ten-year US Treasury bond. The S&P 500 now trades at a forward price to earnings multiple of 21.5 which equates to an earnings yield of 4.65%. This is essentially even with the ten-year yielding 4.6% and implies that bonds are relatively attractive when compared to stocks. Given that stocks are riskier than bonds, investors usually require a larger positive spread in order to invest in the equity market. The longer that yields stay high, the greater the chance that investors rotate towards fixed income and draw capital away from stocks if they see sustained relative value in bonds.

We must emphasize that comparing the equity earnings yield to Treasury rates is a very blunt tool. Earnings can surprise to the upside; Treasury yields may drop; equity multiples could continue to expand; and the economy may race ahead. Any of these outcomes would likely result in strong equity market performance. However, an elevated multiple raises the bar for earnings growth, reduces the margin for error that investors will tolerate, and increases the prospects for more volatile markets. Valuation is not an effective short-term timing mechanism, but it can provide insight on longer-term returns.

Long Run Equity Forecasts

When equity markets appear expensive it can be a good time to take a step back and consider what range of future returns can be expected from today’s elevated starting point. Valuations matter because buying assets that are fully priced makes it difficult to generate outsized returns. Better deals are to be found when assets are on sale, not when they are expensive. This topic recently gained significant attention when Goldman Sachs published a research piece by their main US equity strategist predicting an average return of 3% on the S&P 500 over the next decade. After the robust 12.6% annual return produced by the S&P 500 since 2010, that headline drew immediate commentary.

Goldman Sachs is far from the only firm that publishes detailed reports forecasting future returns. Most large investment banks and asset managers produce similar reports using slightly different methodologies that are intended to help inform portfolio level asset allocation decisions. Inputs for portfolio modeling tools based on modern portfolio theory require estimates for future returns, volatility, and correlations for major asset classes to try and determine optimal portfolio combinations that balance risk and return objectives. The estimates for future equity returns draw the most scrutiny and are the most difficult to calculate. One can simply assume that long-term average returns will continue, but after a period of well above trend returns from the US equity market just, assuming the average would potentially overstate returns over the next decade.

There are a host of ways to attempt to model future returns for the equity market, and this is not meant to be an exhaustive academic paper on the strengths and weaknesses of each methodology, but we would like to touch on three approaches to illustrate current estimates: 1) a simple mean reversion forecast, 2) a return derived from a bottom up assessment on profits and valuations over the next decade, and 3) a more complex regression model that incorporates custom variables to provide a forecasted return. All yield different results, but interestingly all point towards lower-than-average equity returns over the next ten years.

Mean reversion is the most basic and does not require a research staff to generate. The average annual return on the S&P 500 since 1980 is 9.7% and if one assumes that over a 20-year period the market should return that amount, after a ten-year run of above average returns one would expect a string of lower returns to drive toward the mean. The past ten years have witnessed a 12.1% average return so this simple approach would forecast a 7.3% average return over the next decade to revert to the long-run average.

The second method, a bottom-up fundamental forecast where analysts estimate future return drivers such as revenues and margins, share buybacks, dividends, and changes to the P/E multiple at the index level, is utilized by many firms. JP Morgan publishes an exhaustive report following such a fundamental methodology, and they expect a 6.7% annualized return from US stocks over the next seven to ten years.

Finally, Goldman Sachs has forecasted a 3% annualized return to large-cap equities with the main headwind coming from possible muted performance from the mega-cap stocks that constitute a concentration in the index today. Their modified model, which removes the market concentration variable, results in a 7% expected return, remarkably similar to the simple mean reversion and bottom-up forecasts.

Practical Impact on Portfolios

This exercise in forecasting returns is not meant to guide immediate trading actions but can inform strategic decisions about asset allocation and portfolio positioning. All of the forecasting tools outlined above are projecting lower than average returns for the S&P 500 for the next cycle within a range of 3% to 7%. For investors with a substantial position in highly appreciated US equities, it would be painful and reckless to sell a significant percentage of that core position, pay capital gains taxes, and redeploy into other assets just because the forward P/E looks expensive today.

Also important to highlight, these forward return estimates assume that an investor only owns the S&P 500. As noted earlier, while the S&P 500 has become increasingly concentrated in a select group of technology firms, the equal weighted and value indices trade at more reasonable levels. It will be prudent to trim from highly appreciated areas such as large-cap growth and rotate towards less expensive value or smaller cap portions of the US equity market, and we have sought to do that the past few years by balancing value and growth. In addition, for portfolios that can bear the complexity and illiquidity of alternative investments, a healthy allocation to real estate, private equity, and private credit can provide attractive returns with risks that are less correlated to the S&P 500.

A combination of these allocation adjustments will help create more durable portfolio returns in a cycle that could prove more challenging for the largest stocks in the index, but no radical changes in allocations are required. US equities should still produce a solid return even after the excellent run they have experienced, but ongoing diversification outside of the largest growth companies will provide portfolios the best chance to produce an attractive total return in the future.

The Long-Term Starts Now

A high-quality US stock portfolio remains an essential core holding, but it needs to be sized appropriately to enable the most attractive long-term returns for a full portfolio. The S&P 500 is dominated by the largest companies to a degree not seen in over fifty years, and its valuation is extended. This creates the potential for volatility if the performance of those top stocks falter, and this risk is only enhanced by an uncertain policy environment from Washington DC.

We seek to balance those risks by holding cash and fixed income as a buffer, allocating to lower priced US value sectors, and adding to select private opportunities. This approach will not remove all risk from portfolios but will provide balance and the chance to optimize returns through enhanced diversification.