The past few years have been good for U.S. stocks. As of the end of 2024, they are up 24.5%, 14.3%, and 12.9% over the 1, 3, and 10-year periods, respectively, as measured by the Russell 1000 index.
What does the future hold for returns? At the beginning of 2025, 10-year Treasury bonds yielded 4.57%. A 10-year TIPS (Treasury Inflation Protected Security) offered about 2.23% above the Consumer Price Index. These initial yields are a good indicator of the return one can expect if they are held for the entire period. We believe these are decent returns given their risk profile. Stocks are historically more difficult to predict. Here are some recent examples of10-year forecasts for U.S. Large-Cap stocks made by advisers we follow:
Goldman Sachs projects a 3% nominal return (before inflation) over the next 10 years.
Research Affiliates forecasted a 0.7% 10-year real return (after inflation) as of November 2024.
Vanguard forecasted a 2.5%-4.5% 10-year nominal return as of November 8, 2024.
The theme in these projections is that these firms estimate low average annual returns for stocks over the next 10 years. To varying degrees, their forecasts are based on the Shiller Cyclically Adjusted Price-to-Earnings Ratio (CAPE). We examine that here with a view toward explaining why these estimates are roughly where they are and what confidence one can have if history is a guide (big caveat here: historical performance is no guarantee of future performance).
The Shiller CAPE ratio is a stock valuation metric that assesses a market’s value by dividing its current price by the average of its inflation-adjusted earnings over the past 10 years, with the belief that it provides a more stable long-term view compared to a standard price-to-earnings ratio. Developed by economist Robert Shiller, a higher CAPE ratio generally indicates a potentially overvalued market and potentially lower future returns, while a lower CAPE suggests undervaluation and higher potential returns. Recently Schiller has added an additional factor to this measure which he calls the total return TR CAPE. The TR CAPE refinement was added to reflect changes in corporate payout policies. Here we use the TR CAPE for our analysis (which we will refer to as CAPE).
Let us look at the data, in particular the relationship between TR CAPE and subsequent performance.
Each point in Figure 1 (above) shows a value of the CAPE ratio horizontally and the subsequent 10-year real return on stocks (source: Shiller). The data is divided into deciles. The current value of the ratio is about 40.8 putting it inside the box (horizontally).
Figure 2 (below) shows the range of returns by decile. The box indicates the range from the 25th to the 75th percentile with a horizontal line indicating the median (50th percentile). The median return has been 0.6% (annual, real) when the CAPE has been in the 10th decile.
The history of CAPE data indicates that future real returns on stocks will probably be lower than average though there are instances when top decile CAPE values produced higher than average results.
Earlier we stated that over the last 10 years, stocks have appreciated 12.9% annually. That is approximately 236% non-annualized. Over the 10 years ending July 2024, corporate profits appreciated about 69% (source: Federal Reserve of St. Louis).
Quoting famed investor Howard Marks, “…when stocks rise too fast – out of proportion to the growth in the underlying companies’ earnings – they’re unlikely to keep on appreciating. “ The data on the CAPE ratio supports this opinion (Figure 3).
Figure 3
Given high current market valuations, we are concerned about the future performance of the overall U.S. stock market. There are essentially three options available to us:
- Do nothing. Ride it out.
- Sell stocks, go to bonds or cash. (When do you get back in?)
- Sell expensive stocks, buy cheap stocks.
Ignoring taxes because they require custom analysis, we prefer reducing exposure to expensive stocks in favor of less expensive stocks. Figure 4 shows that the large growth segment of the S&P 500 is the most expensive based on percentage of the current P/E relative to the 20-year average.
Figure 4 Source: JP Morgan Asset Management Guide to the Markets 1Q 2025
The U.S. is not the only stock market in town. Its share of the global market capitalization has risen to 67% from a bit over 30% in 1987. Stocks in developed countries outside the U.S. appreciated 5.2% over the last 10 years. Emerging market stocks returned 3.6%. As Figure 5 illustrates, stocks outside the U.S. appear to be a relative bargain based on price-to-earnings ratios.
The appropriate course of action depends on individual circumstances. We encourage you to discuss this with your advisor to decide what is best for you.
A Note on Taxes
Selling one investment to buy another in a taxable account will have tax implications. The impact will vary depending on factors like the tax rate. There are several points we want to make here. The first is that, in our experience, investors put too much emphasis on taxes.
If you expect to sell your stocks in your lifetime, then you will eventually pay the capital gains tax. Not selling now defers the tax rather than avoids it. The tax deferral is usually not worth much. Another way to evaluate the decision to sell is to consider the excess return an alternative investment will need to earn to make up the difference in after-tax value. Let’s use an illustration.
Figure 6
Example: An investor has $1 million in stocks. These have doubled in value since she bought them for $500,000. That’s a 100% increase. The investor would pay 29% in federal and state capital gains taxes if she sells them now. This would leave $855,000 after-taxes. Let’s assume the investment will grow at 3.5% for the next 10 years (in line with the forecasted expectations shown above). It turns out, an alternative investment would only have to earn 4% to make up the difference in after-tax values over the next five years as shown in Figure 7.
If you can afford to hold the stock until death thereby allowing your heirs to enjoy a step-up in basis, then the capital gains taxes can be avoided. That is a different analysis and the hurdle becomes higher. The excess return required to break-even will depend on the amount of gain, the tax rate, and the horizon over which break-even is required. Selling today certainly incurs taxes. The excess return is uncertain. We recommend requiring an expectation of excess return well over what is needed to break even.
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IMPORTANT DISCLOSURES
The analysis in this report has been prepared by Red Tortoise LLC (“Red Tortoise”) utilizing data from third parties. Reasonable care has been taken to assure the accuracy of the data contained herein and comments are objectively stated and are based on facts gathered in good faith; however, Red Tortoise cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Red Tortoise disclaims responsibility, financial or otherwise, for the accuracy or completeness of this report. Opinions expressed in these reports may change without prior notice and Red Tortoise is under no obligation to update the information to reflect changes after the publication date.
This report is being made available for educational purposes only and should not be used for any other purpose. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any investment advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Past performance is no guarantee of future results. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. The foregoing represents the thoughts and opinions of Red Tortoise, a registered investment advisor. This report, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Red Tortoise.
