Rob Arnott warns that shareholders in U.S. big caps will make one-fifth the returns over the next 10 years they pocketed since 2016, and those meager gains will barely edge the CPI. You may want to take a cold shower, or a shot of tequila, before you hear the convincing logic behind his dour prediction.
Arnott is the founder and chairman of Research Affiliates, a firm that oversees strategies for nearly $200 billion index funds and ETFs for the likes of Charles Schwab and Invesco. He served as editor-in-chief of the Financial Analysts Journal in the early 2000s, and today co-manages the Pimco All Asset and All Asset All Authority funds. He’s also the father of “fundamental indexing,” the practice of weighting stocks in by their size in the economy rather than chasing expensive “winners” by ranking according to market cap. At RA, Arnott’s bred a think tank in its own right featuring sundry PhDs who apply advanced statistical research to forging benchmark-beating vehicles.
So I check frequently with Arnott to get his take on what those buying into the S&P 500, or baskets of big cap U.S. stocks, are likely to reap in the years ahead. It’s an especially good time to get a sober reading. The S&P’s dropped 4.4% from its record close in January, and the Iran war and jump in oil prices and Treasury yields following the attack are raising a new cloud of pessimism.
An advantage to consulting the sage: Though his predictions are based on a sophisticated analysis of past trends, the future math is basic. In our conversation over Zoom, Arnott stressed that returns have three sources, dividends, growth in earnings (that lift payouts in tandem), and expansion in valuations or PEs. The last ten years, he avows were something of a seldom-seen, golden age for this trio, but especially profits and multiples. “Overall, U.S. large caps [as reflected in the S&P 500] produced overall gains of 15.5% a year, an extraordinary number,” says Arnott.
The rub: The fantastic profit and PE performance over the past 10 years virtually guarantees a rough road ahead
Arnott emphasizes the gap between the historic trends in both profits and valuations, and the S&P’s extraordinary outperformance from mid-March of 2016 through today. Earnings-per-share waxed at over 11% annually, almost twice their long-term average. The S&P multiple ramped by around one-fifth from the low-20s to roughly 27.5, the current number according to FactSet. “In effect, the big returns were front loaded by that highly unusual scenario,” says Arnott.
But the high times also foreshadowed today’s downside. Starting at these heights in both metrics, he adds, “has the effect of reducing future returns.” The Wall Street market strategists’ view that anything resembling the last decade’s results are repeatable amounts to a fantasy, declares Arnott. “PEs don’t always go up without limit,” he says. “In no sensible world is that plausible.” Arnott contends that it’s equally illogical to argue that EPS can keep advancing five points or so faster than their long-term average. As everyone from Warren Buffett to Miltion Friedman has pointed out, profits can’t outgrow the economy forever, and after they absorb an unusually large portion of national income, shrink back towards the norm going forward.
Here’s the picture Arnott foresees over the next ten years. Because stocks are so pricey, the dividend yield now sits at a mere 1.2%, way below its contribution in most periods. (The stats are available on RA’s website under “Asset Allocation Interactive”.) As for profits and PEs, he cites one of the laws governing markets: reversion to the mean. In the RA scenario, earnings will wax at 5.3%, more or less matching their traditional trajectory, less than half the 2016-2026 pace. Add those two components, and you get a “plus” of 6.4% a year. That already sounds mediocre. But the big hit’s a shrinkage in multiples that severely reverses the potent upward push that helped generate those 15.5% returns since 2016. Arnott predicts that valuations will shrink by 3.4 points a year, or 40% by 2036. That pressure would reduce today’s PE of 27.5 to around 17. Although that sounds extremely slender versus what we’ve seen in recent years, it’s more or less the multiple in the years leading preceding the pre-GFC boom, and close to the 120-year mean.
All told, the overall S&P 500 should then deliver total annual returns of 3.1% (6.5% from dividends and growth, minus 3.4% from a decline in the PE). That’s one-fifth the mark for the past decade, and exactly one point better than projected inflation of 2.4%. By 2036, the S&P would stand at 8073, just 21% above its reading of 6672 at the close on March 12.
To gauge just how hugely this outlook diverges from the conventional wisdom, consider that the Wall Street consensus calls for the S&P to end this year at between 7600 and 7650, or less than 6% short of where RA expects the index to finish ten years hence.
Arnott tags the Mag 7 and other high-flyers for pulling the big returns forward, and advises to shun them
Arnott also highlights a significant difference in prospects between the S&P value and growth contingents. The RA model predicts 4% annual gains in the former and a shockingly puny 1.4% in the latter, meaning the recent champs’s returns will lag inflation by one-percent. Much of the drag, he says, arises from the big valuations, on top of earnings so gigantic they’ll be hard to grow big from here. A major reason we saw that double-digit EPS boom rampage, he avows, “is the stupendous growth in the Mag 7.” Now, he adds, “Valuations for growth stocks are very stretched, driven by the Mag 7. The market’s saying it’s a foregone conclusion they’ll grow earnings like crazy. But to beat the market, they’d need to grow earnings even faster than those lofty expectations.”
Arnott’s especially skeptical of the premium prices awarded by investors expecting fantastic profits from AI. “The companies making money from AI are the ones selling the tools,” he says. “They’re now lending to their own customers so that those customers can keep buying their stuff. And their customers are having a hard time monetizing that equipment.” Arnott related that he’d just used Perplexity to perform an in-depth study of how various tax increases being proposed would affect marginal rates at different income levels, and paid nothing for the service. “These AI providers will figure out how to make money,” he says. “But not as fast as the expectations that are built into their stock prices. It will be a slow build over a long period, meaning returns on these stocks will be much lower than the market’s baked in.”
Here’s his advice: “If you’ve owned the Mag 7, say ‘thank you very much, Mag 7,’ and get out and don’t ride them back down.” Arnott believes that returns will be much bigger outside the U.S. than stateside. For example, RA posits that developed nation, non-U.S. value stocks will provide 7.4% returns going forward, more than twice the expectation from the S&P 500, and that emerging markets value shares will do even better at 7.6%. Arnott concludes that the best strategy is to “first, own no U.S. shares or at least lighten up, and second, own no growth stocks anywhere.”
Versus what we’re hearing from Wall Street, and the S&P’s spectacular showing over the past decade, Arnott’s perception is highly contrarian. But the math’s on his side. And when the math contradicts belief and momentum, go with the math.
