Buy and Hold is Under Threat
Many bears criticize buy and hold. Buying and holding the S&P 500 has delivered 10.7% annual average returns since 1950, and the lowest real return over any 20 year period after 1920 has been 0.3%, from 1962 through 1982. Yet, bears often cite something along the lines of “this time its different” to deter investors from buying and holding stocks.
Some suggest the large increase in debt will lead to a prolonged market crash that will last decades. These bears will often mention the term “bubble” then cite valuation metrics such as the Buffett Indicator, S&P Price Regression, or Shiller PE, all of which have significant data issues as I’ve continually highlighted due to changes in the expected mean over time, which poses an issue for any time series analysis. Despite these data issues that would invalidate some of the conclusions of the time series analysis, bears continue using the long-term data to support their bearish conclusions, which should be called out as potential statistical malpractice.
In summary, the Shiller PE doesn’t reflect changes in buybacks and CPI over time, so recent readings will be excessive, relative to historical readings, all else equal.
The S&P Price Regression doesn’t reflect the shift from dividends to buybacks in terms of capital returns. And the Buffett Indicator is an apples-to-oranges comparison comparing the S&P 500 which derives nearly half of sales overseas, with US-only GDP, which doesn’t capture the robust, faster global GDP growth over the last several decades.
Is the US like Japan?
In two words—absolutely not.
First, Japan has saw its working age population decline at near 1% annually since the year 2000. It becomes very difficult to generate any meaningful economic growth with that sort of work force decline, since even 1% productivity in conjunction with a 1% decrease in work force would generally lead to zero real economic growth. Then, consider the deflationary nature of such demographics, and historically large debt build up, then it becomes possible to have near zero nominal GDP growth over a long period of time.
Japan is an extreme version of what other developed nations like the EU, and China will face in the coming decades, as they face more modest declines in the working age population which will cause deflationary pressures and also pressure real GDP growth, which will lead to stagnating nominal GDP growth.
However, the United States is poised to continue to have working age population growth, although more modest in the 0.5% per year range for 2020 through 2050, compared to the average from 1970-2010 which was north of 1%.
Given the aforementioned poor demographics for Japan, it is no surprise that Japan’s nominal GDP has barely grown 10% cumulatively from 1994 through 2018, which is barely 0.4% annualized average nominal GDP growth. In the long run, corporate earnings grow roughly with nominal GDP, so although global growth has been faster than that, and some Japanese companies are global corporations, the strong Yen relative to most other currencies over the period since 1994 likely negated the benefit of faster growth from the faster growing global economy. Therefore, Japanese companies have been faced with near flat nominal GDP since 1994, so it is no wonder why the stock returns for the Nikkei have been poor since 1990.
In Japan, at roughly the peak of the Nikkei at the end of 1989, the trailing PE Ratio was around 60x, so even assuming very robust forward growth the forward PE like stood north of 50, but let’s just use 50. This doesn’t consider that those earnings soon collapsed with Japan entering a recession in the early 1990s after one of the most pronounced economic booms in global history.
However, in 1989, if we assume the Nikkei needed to collapse to a more normal PE ratio of 15, then it would require a plunge in cumulative PE ratio of around 70%. If this were to happen over the ensuing 30 years after 1989, then it would be a 3.9% annualized contraction in PE Ratio. In conjunction with massive PE contraction, one could have only expected minimal earnings growth with flat nominal GDP from the early 1990s to present in Japan. As noted above, the nominal GDP grew at an annualized rate of 0.4% from 1994 through 2018. Let’s assume a generous 1% per year nominal GDP growth. The starting yield was under 1% in 1990, so generously assume a 1% yield.
So, at year end 1989, if one had a good GDP forecast, he could have seen roughly 1% annual EPS growth tracking nominal GDP, a 1% Dividend yield, and then a required 3.9% annualized PE ratio contraction for the next 30 years. Therefore, it would have been projected that the annualized return from 1990 through 2018 would have been approximately negative 1.9% if we approximate the return by adding 1% EPS growth plus the 1% dividend yield, minus the 3.9% annual contraction in PE ratio. The actual annualized return over the period was negative 1.9% (From December 1989 through August 2018). Therefore, the horrid returns from 1990 to present for Japan should not have been unexpected—it was the predictable result of an insanely high bubble valuation in 1989 in conjunction with total stagnation for the next 30 years in economic growth due to poor demographics which were predictable.
Buybacks have never been large in Japan so assuming earnings for the Nikkei grow at nominal GDP becomes reasonable.
In 1989, although the Japanese economy had been previously booming, it was guaranteed that population growth and workforce growth would turn negative within a decade based merely on birth statistics and death statistics, so it is no surprise it would take down real economic growth significantly, and curtail inflation. Maybe one wouldn’t necessarily forecast such a slow 1% annualized nominal GDP growth for the next 30 years in 1989, maybe we only know such gloomy growth in hindsight. But anything more than 2% inflation when the workforce population is about the decline and 1% real growth seemed to be excessive in 1989. Therefore, even if we try to remove hindsight bias from 1989 forecasts, and assume nominal GDP growth would have grown 3% per year from 1989 and forward, then the return we could have expected would have been positive 0.1% for the next 30 years---that also indicated sheer danger for Japanese stock investors for the next 30 years. Therefore, the debacle of the Nikkei returns from 1989 through 2018 should not have been unexpected, based on items that were known to be factual in 1989—that the PE ratio indicated a mega bubble that would need to deflate, and that demographics suggested a drop in nominal GDP growth that can be sustained. Even if someone underestimated the decline in nominal GDP by 2 full points, he should have still foreseen near zero returns for 30 years, a horrible outcome.
The US is Different
In the US, the demographics foretell us that it is highly unlikely that we see flat or anything near it in terms of GDP for next 25 years, with population work force projected to keep growing at 0.5% per year for decades.
Also the current S&P 500 PE is just under 16 on a forward basis, and the current dividend yield is about 2.0%. Then, we project that inflation slows to just 1.5%, which is below the 1.8% annualized for the last 10 years. Keep in mind that the US demographics will be better for the next 30 years in terms of working age population growth, than it has been for the last 10 years, so this is conservative. Also, let’s assume Real GDP growth slows to just 1.5%, below the Fed’s long run target of 1.8%, with the 1.5% real growth reflecting 0.5% projected working age population growth from the demographics, and then 1% annual productivity growth. Therefore, we would assume US nominal GDP would grow 3.0% annually with 1.5% inflation and 1.5% real growth. Actual growth pertinent to US stocks can be greater since over 43% of S&P revenues are overseas, and with world GDP growth projected to be much faster than that of US, but to be conservative, let’s assume a stronger dollar would offset any benefit of faster global growth, like what largely happened in Japan for the last few decades.
The current run rate of buybacks for the S&P is north of 3.0% of market cap, let’s assume that slows down a bit plus there’s some dilution from equity issuance, so assume conservatively 2.0% annual share count reductions. Therefore, we can assume S&P earnings would grow in the long run at 5% reflecting 2% annual share count reduction and 3% nominal GDP growth.
If the current forward PE of 16 barely needs to contract in a meaningful manner to hit a long-term target of 15, then over the next 30 years, the required contraction would be 0.2% per year. Then add on the conservative 5.0% EPS growth and 2% current dividend yield, we would see the conservative long run returns for the S&P of 6.8%, which is well above the -1.9% annualized returns for the Nikkei of the last near 30 years. Even if there was no growth in nominal GDP instead of 3.0%, then the returns come in 3 points lower or 3.8%, which still is far from the nightmare scenario of Japan where returns were negative for a 30 year period. Now 3.8% is a very poor return, but it would still beat the current 3.1% yield on a 30 year Treasury bond, and that isn’t that poor considering it assumes no nominal GDP growth for 30 years, which is consistent with an extremely poor economy. Exceeding the return on risk free Treasuries by 70 basis points over a period when the economy hypothetically doesn’t grow for 30 years, which is historically horrible on a global scale, is a pretty good relative investment outcome.
What about 1999?
If the S&P 500 had the insane mega bubble valuation in 1999 as the Nikkei did in 1989, then the S&P 500 would have traded at a forward PE around 50, instead of 25. Therefore, the S&P 500 would have peaked around 3000 instead of about the 1500 level. So if investors had bought the S&P at 3000 in the year 2000, as of year-end 2018, they would have seen average annual returns in the 0.9% range since 2000, with negative 1% per year in capital gain offset by an approximately 1.9% average dividend yield over the period. The 0.9% annual return since the year 2000 if the S&P traded at the same valuation roughly as the Nikkei peak in 1989 is a poor return, but not quite as bad as the negative 1.9% from Japan from 1989 to 2018. The disparity is mostly driven by the US economy showing much more robust growth in nominal GDP from 2000 through 2018, which translated into corporate earnings growing sharply. Operating earnings for the S&P grew from 57 in the year 2000 to a projected 158 in 2018, which is far from stagnation. Japan, facing very poor demographics after its bubble burst, did not see such nominal economic growth and therefore earnings growth to bail out investors a bit by offsetting the PE contraction following the bubble bursting.
Buy and Hold is still alive and well. Buy and hold appears impervious to attacks from the bears about using time series valuation methods that have significant issues with changes in means across time due to inconsistent underlying market data which jeopardizes the like-to-like comparison.
Additionally, attacks on Buy and Hold in terms of the US stock market are not threatened by references to the investors who bought the Nikkei in 1989. Those investors who bought the Nikkei in 1989 paid roughly 50 times forward earnings with a future that would see a demographic collapse, the most bearish confluence. Investors in the US in the year 2000 only faced bubble valuations (25 times forward earnings), but the underlying economic backdrop and demographics for the long run future were much better, relatively, so these investors still received positive real returns since 2000.
However, current investors in US stocks are much more fortunate, for they are not paying 50 times forward earnings with a poor demographic future like in Japan in 1989 when they could have sat in risk free long term bonds and received at least 5% yields, nor are they paying 25 times earnings with a stable long term economic backdrop like the US in 2000 when they could have sat in risk free Treasuries and got yields around 6%. Current US stock investors in 2019 are paying barely 16 times forward earnings for the S&P 500, with future long run demographics that are not terrific, but appear at least fair enough to remove the chance of a deflationary and stagnation nightmare like Japan, while at the same time the investors are presented with a less favorable alternative opportunity cost via the 30 Year Treasury bonds which barely yield 3%.
Disclosure: I am/we are long IVV, VOO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.