Better than zero

This seems like a bad time to be an index investor.

The market's impressive return since November is getting investors excited again, so it's time to dampen that euphoria with a realistic look at future returns.

By my estimates, the S&P 500 looks likely to provide a poor return of 3% over the next five years. After inflation, taxes and fees, I think someone investing in or holding an S&P 500 index fund or ETF will be lucky to break even. I doubt many investors expect or want such returns.

I base my estimate on normalized earnings per share of the S&P 500 since 1948, which have grown at a remarkably steady rate of 6% per year over that time.

Add a 2% dividend to that growth, and it seems like you'd get an 8% return. But, you have to keep in mind the price you pay for those earnings and dividends.

Currently, the S&P 500 is trading at around 19 times normalized earnings per share, but the historic average since 1948 is closer to 15 times. Going from 19 to 15 times earnings over the next 5 years would subtract 5% from returns each year, leaving you with the 3% I mentioned above.

Inflation since 1948 was a bit over 3%, not to mention the dent from fees (even low fees of 0.2% will hurt). The end result is a 0% or less annualized, after-inflation return over the next 5 years--not very enticing.

Like all estimates, mine, too, may turn out wrong. The economy may grow less than 6%, especially with the debt and entitlement burdens the U.S. faces (see the work of Reinhart and Rogoff for their take on why GDP growth is likely to slow).  

Inflation may be more or less than I forecast. Dividends could be higher, too. But growth, inflation and dividends are unlikely to be far different than my estimates, meaning the actual result may be a bit higher or lower, but essentially the same.

The multiple to earnings may go much higher or lower on it's way to 15, too. In 2000, it topped out at 37. In 2007, it topped out at 26. Assuming that will happen again and that you can time getting out at that top seems a bit foolish, though.  

On the low end, the earnings multiple could drop below 10, like it did in the late 1940's and mid 1970's to early 1980's. Such lows would mean significantly negative after-inflation returns (which would almost certainly be temporary in nature).  

Like I said above, you can play with the numbers a bit and come out with slightly different outcomes, but the underlying math won't move the meter much. Index investing looks like a poor option from here.

What are the alternatives? Bond yields are dismally low, and a spike in inflation would quickly eliminate that yield. Commodities (including gold) may continue to soar, but a hard landing in China's economy seems a distinct possibility, and could easily gut that return overnight. Real estate may be coming back, but the high returns seen from the 1970's to mid 2000's will not return.

What's left?  For me, stock picking seems to provide the best answer (not surprisingly, I'm talking my own book, here). Some of the companies in the S&P 500 will thrive and some will dive, and successfully picking the thrivers could generate acceptable, though not outstanding, returns over the next five years.  

Buying companies at 10 times earnings that, on average, grow at 6% a year and pay dividends of 3% provides a return of 9%, even with no multiple expansion to the 15 average seen historically (which would obviously increase returns). Taking away 3% inflation and management fees of 1.5% gives a 4.5% pretax return. This may not make you salivate with greed, but it would mean your money would grow by 25% in real value over the next 5 years instead of shrinking.  

There are no guarantees such an outcome will occur, but I feel quite comfortable putting my money into situations with that type of underlying math.  

Index investing may have low fees, but low fees on no return seems like a poor deal to me.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.