Updated: Jul 31, 2021
The S&P 500 hits a new high again on Friday (23rd July) despite some bearish momentum earlier in that week.
Throughout the past few months, S&P 500 has been constantly making new highs. In fact, the index has already made a gain of ~17% (as of 23rd July) YTD. With four more months to go for the remainder of this year, there is probably a good chance that this gain will cross into the twenties region.
(Source: Portfolio Visualizer)
If we were to look at the annual gains of the index across the past few years, such a gain YTD is likely to surpass what we already have in 2020 though it's probably unlikely to surpass what we have in 2019. If this momentum is to continue, these past 3 years (inclusive of 2021) are likely to be some of the best 3 years of index investing with an annual return way above 15%.
Imagine if we were to go back a bit more into the history, how much of a deviation is this year's performance relative to what we have in the past few decades?
Above is a graph obtained from a report from JP Morgan. Taking forward P/E ratio as the benchmark, the 25-year average for forward P/E ratio for S&P 500 is 16.71X. As of 30 June 2021, the forward P/E ratio for S&P 500 is 21.53X. The current ratio is probably higher as the index has made new highs since then. Such a high forward P/E ratio is significant as it is more than 1 standard deviation from the average value.
Statistically, what can we expect from the future returns of investing in S&P 500 then?
That depends on your investment horizon.
If your investment horizon is one year, here is how it will look like.
You will get a wide range of possible returns (probably anywhere between +20% to -30%) as an investment horizon of one year is too short to get any effects of expected long term trends on it. When you plot the line of best fit across all the returns and their corresponding forward P/E ratio across the history, you realise that the R-squared value is only 6% which represents very low confidence of accurately giving an expected return value based on the corresponding P/E ratio. I once wrote about R-squared value here. You might like to check it out.
lf your investment horizon is five years, then things will start to look different.
You notice that the data points are much more concentrated in this five-year chart as compared to the one-year chart. The R-squared value is also much higher which indicates a much higher confidence of the prediction model. At a value of 21.5X, the expected annualised return is almost 0%.
And such sentiments of potential diminished future returns are also echoed in the recent GIC report. In the CEO's letter of the recent report, caution on macro environment is exercised amid the stretched valuations. It's highlighted in the report that returns from a broad range of asset classes are expect to be low in the next five to ten years.
So what can we do as retail investors if we are in for the long haul (eg. 5 to 10 years)? What can we do to increase our chances of getting good returns for our portfolio if index investing has a good chance of underperformance in this time period?
In the same GIC report highlighted above, it's also highlighted that there are potentially silver linings amid the cautious macro environment. These silver linings come in the form of identifying emerging long term trends and pursuing the right investment opportunities amid these trends. Examples of these trends are sustainability, technological transformation and geo-politics. Personally, I am in agreement and have taken a shot with thematic investing in my current portfolio and will likely continue to do so in the next few years.
Examples of thematic investing which I am doing now includes identifying ETFs which specialised in certain themes (eg. ARKK).
Besides thematic investing, I do also think that it's probably worthwhile to look at other markets which have been greatly underperforming so far. While the US market is having a fantastic year, the China market isn't really doing so well (I have written an article on it). And I'm glad I'm not the only one who thinks so. GIC is also upbeat on China tech.
So if you are investing with a time horizon of 5 to 10 years, it's probably timely for you to start paying attention to thematic investing or other geographical markets if your way of investment is purely via index investing in the US market. Of course, if you are only looking at results in 1 year or so, all of these probably will not make any difference.
My recent model has also begin to show bearish indicators for SPY in the coming months. Check it out here.
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