Lower returns look likely

Rising P/E ratios not sustainable

As equity investors continue to shrug off risks like a potential war with North Korea and unpredictable policy out of the White House, the S&P 500 appears to have resumed its upward trend, as it continues to hit new record highs.

While calls for a market pullback won’t dissipate anytime soon (they never do), it’s worth taking a look at where we came from, before assessing what the future might look like.

Going back to March 31, 2011 — an appropriate point in time to avoid recessionrelated market distortions — the S&P 500 has generated a total return of 110 per cent. While 26.8 percentage points came from dividends, 54.8 percentage points came from a rising price-to-earnings ratio.

Eric Lascelles, chief economist at RBC Global Asset Management, noted that just 29.1 percentage points came from rising earnings per share.

“This is mostly bad news in that we would prefer if the entirety came from robust earnings growth,” he told clients.

Since half of the U.S. equity market’s total return came from rising multiples, investors should be concerned. After all, this driver can’t propel stocks higher forever. As Lascelles pointed out, the P/E ratio is a meanreverting variable, at least in theory.

The good news is that the S&P 500’s P/E ratio rose from a very low level to something much more normal, particularly when you consider how low interest rates have been. That’s why the economist thinks P/E gains don’t necessarily need to be given back. However, he does doubt that a rising P/E can contribute another 54.8 percentage points to market returns in the next six years.

Digging deeper into the paltry 29.1 percentage point contribution from EPS growth doesn’t paint a very pretty picture either. A closer look at revenue growth — considered the primary driver of earnings growth, and therefore equity returns — shows that it made up roughly half of the earnings gain (14.9 percentage points). Lascelles noted that as a result, revenue growth rose just 2.2 per cent annually in slightly more than six years.

“Instead, nearly half of the earnings per share growth in recent years came from two other places that are much less reliable as drivers of future earnings growth,” the economist said, pointing to expanding profit margins and share buybacks.

Unfortunately, higher wages and more expensive borrowing costs (via rising interest rates) could put a lid on improving near-term profit margins, and share buybacks are unlikely to continue forever as the Fed raises rates and business investment picks up.

“Viewed through this framework, the total rate of return on equities in coming years is unlikely to be as good as the performance over the past six years,” Lascelles said.

The economist is confident that stocks will continue to rise, as dividend payouts look sustainable and revenue growth could improve with a strengthening economy.

However, investors should temper their expectations in anticipation of returns coming from different sources than they have in the recent past.