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The S&P 500 (the ‘S&P’) has been on a tear in recent years.  During the 10-year period ending March 31, 2024, the S&P averaged 13.0% per year (including dividends).  That is a great return.  With the exception of the NASDAQ, it’s beaten nearly every benchmark out there.  As we noted in a year-end letter to clients in December: “Consequently, any equity portfolio holding something other than US large cap stocks has likely not performed as well as the S&P.  That has been the curse of diversification over the past few years.”

 

So, what happens next?  Why not just put everything into the S&P today?  It’s done so well, right?  It has.  And that’s kind of the problem.

 

Because it’s done so well recently, the odds of a repeat performance (another 13% per year for the next ten years), at least in our view, are low.  In fact, I think a reasonable expectation for what we’ll get over the next 10 years (starting on April 1, 2024) on the S&P is somewhere between 4% and 7%.  I’ll explain why below.

 

But first, some background.

 

Stock returns (whether an individual stock or an index) come from the combination of three things:

1.     Dividends

2.     Growth in earnings per share, and

3.     The change in the valuation attached to those earnings, measured by the change in the PE ratio

 

That third item, the PE ratio, requires a bit of explanation.  The PE ratio is just the current price divided by the last 12 month’s earnings.  It can be affected by a variety of things (e.g., market psychology, interest rate expectations, perceived business risk) but generally interpreted as the market’s expectations for future earnings growth.  If the PE ratio is high, growth expectations are generally high.  If the PE ratio is low, growth expectations are generally low. 

 

The PE ratio is kind of the wild card in our little returns equation above.  When it goes up, it helps returns and when it goes down it hurts them.  There’s a catch though.  the PE ratio cannot go forever up or forever down.  It moves in a range.   And it tends to be mean reverting.

 

Over the long term, what the PE ratio giveth, the PE ratio tend to taketh away (and vice versa, of course).

 

So, what did the S&P PE ratio do over the past 10 years?  It increased from about 18 to about 27[1].  That helped returns a lot.  In fact, I estimate that about one third of the 13% return on the S&P over the past 10 years came courtesy of that increasing PE ratio.  Not dividends.  Not earnings growth.  Just increasing valuations.

 

The PE ratio has been in giveth mode over the past decade. 

 

Here’s why that’s not likely to continue:

 

Remember our formula above: returns = dividends + earnings per share growth + PE ratio change (this sum is not exact due to the math of compounding, but I’ve corrected for that in my calculations). Let’s use that formula to see what the PE ratio would have to be 10 years from now to get another 13% per year return over the next decade starting April 1st this year.

 

The current dividend yield on the S&P is about 1.4%.  That’s a reasonable estimate for what we should expect from dividends over the next 10 years.

 

The S&P’s earnings per share (including inflation) grew a bit less than 7% per year over the past decade so let’s assume we get 7% over the next 10 years (which, incidentally, would be very good – I’ll return to this point at the end).

 

Add those two and you would get returns of about 8.4% over the next decade.  But wait, we want 13%!  That means we need an increasing PE ratio.

 

To get 13%, the S&P PE ratio would need to go from about 27 today to about 41 ten years from now.  How likely is that? The only time the S&P PE ratio has been above that in the past 35 years is in the aftermath of the tech bubble in the early aughts and the aftermath of the Great Financial Crisis in 2008-2009.

 

What if, instead, the PE ratio goes down over the next 10 years?  Let’s say it comes back to a more normal-ish value of 20 ten years from now.  If that happens, your total return over the next 10 years on the S&P would be about 5.2%.  By the way, I picked 20 because about 70% of the time over the past 35 years it’s been between 15 and 25.

 

Now, could PE ratios stay higher for the long term?  Of course. There are good arguments for this (think tech-enabled business models here: less capital intensive, higher return on equity).  But assuming they stay higher is a bet against history.  Who wants to take those odds?

 

Let’s look at another measure.  Check out the following chart of the Shiller Cyclically Adjusted PE ratio over the past 20 years.  The Shiller PE is a widely used modification of the traditional PE ratio meant to average out the short-term noise of earnings volatility associated with business cycles.  Like the normal PE ratio, the Shiller PE moves in a range (i.e., it doesn’t go up or down forever, and it tends to be mean reverting).

 


Note where the Shiller PE is as of March 2024 compared to where it was 10 years ago.  It’s increased from about 25 to about 34.  Over the past 140 years or so (yes, 140 years), the Shiller PE has been higher than it was on March 31, 2024 on only two other occasions: in 2021 and in the late 90s tech bubble (not shown in the chart). 

 

What would the Shiller PE ratio have to be 10 years from now for us to get another 10 years of 13% annual returns from here?  Let’s use the same assumptions as above: dividend yield of 1.4% and earnings growth of 7%.  We also have to make an inflation assumption for the Shiller PE ratio calculation, so I’ve assumed 2.5% per year.

 

Based on my calculations, to get 13% over the next 10 years would require the Shiller PE ratio to hit about 50 ten years from now.

 

It’s never hit that level.  Not in 140 years.  Not even in the 90s tech bubble (which was the highest it ever hit).  Still, is it possible?  Yes.  Is it likely?  Do I need to answer that?

 

What if the Shiller PE ratio comes back down to something a little more normal (by recent historical standards)?  Let’s assume it’s at 25 ten years from now.  If that happens (and using the same dividend and earnings growth assumptions from above), the total annual return on the S&P over the next ten years would be about 5.5% (very close to our estimate using the normal PE).

 

At this point, it might be tempting to say, ‘well, fine, I get that valuations are high, but I think earnings will grow faster than 7%’.  Maybe, but I think that’s unlikely also.  Corporate profits are a component of GDP and those are already near historically high levels as a percent of GDP.  To have those grow faster, you need GDP to grow faster and/or to have profits become an even greater proportion of GDP.  Seems unlikely.

 

If you’d like just one more data point to chew on, consider this historical tidbit: over the past 30 years, if we look at all of the periods in which the S&P returned 12% or more over any consecutive 120 month period, and then, for those periods, look to see what the S&P returned over the next 10 years, we find the following: the average annual return for those subsequent periods was just 1.6%.  And the very best was 7.7%.

 

The S&P had a great run over the past decade.  Just don’t expect a repeat. 

 

To be clear, I’m not saying it can’t happen.  Just that it’s not likely.

 

You know, math and history and all.

______

[1] I’ve used estimated earnings per share for Q1 of this year (source: S&P) in all calculations since actual results for Q1 have not yet been fully reported.


Disclosures:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.  There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. Index returns are unmanaged and do not reflect the deduction of any fees or expenses.  Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.  You cannot invest directly in an Index. Past performance shown is not indicative of future results, which could differ substantially. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of Setarcos strategies are disclosed in the publicly available Form ADV Part 2A.


Setarcos Wealth Advisors LLC (“Setarcos”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Setarcos and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at setarcosllc.com.

  • Stephen Way

How Wealth Advisors Can Help do Tax Planning for The Two Types of Taxpayers


Effective tax planning is an important component of building wealth and is generally split into two time periods: near-term (i.e. the current tax year) and longer-term (beyond the current year). Near-term tax planning is primarily focused on minimizing your current tax liability and avoiding surprises and penalties at the tax deadline. Longer-term tax planning is primarily focused on strategically minimizing your taxes over your lifetime, even if it results in paying more taxes in the current year.


Another aspect of near-term planning is managing your federal and state tax liabilities through your withholdings and/or estimate tax payments. How you actually pay them depends on how you feel about managing your obligations throughout the year and your comfort with surprises come tax time. In general, this tends to push taxpayers into one of the camps when it comes to paying taxes throughout the year.


  • Those with a preference to avoid negative surprises and penalties (most, but not all taxpayers)

  • Those whose preference is not giving the IRS an interest-free "loan" (and may not care too much that they may owe taxes and penalties at the deadline)


Most taxpayers don't like a "negative surprise" when they file their taxes, obviously. There are a lot of reasons why you may find yourself in this unpleasant situation. A common reason is that you may not be withholding enough taxes from your paycheck. This issue is particularly acute with equity compensation such as Restricted Stock Units (or RSU's) since the federal statutory withholding rate is a flat 22%, which could be much lower than your marginal tax rate of 32% or 37%. Another reason is not withholding taxes for portfolio income (dividends, capital gains, etc.).


Often an unexpected tax liability will also include a penalty for not meeting the required quarterly tax payments. Just because you're withholding taxes regularly doesn't mean you're withholding enough to avoid penalties (you can read more about estimated tax payments here).


Penalties accrue based on required quarterly payments, and while often not significant in dollar terms, penalties can be a source of frustration, akin to getting a parking ticket. However, there is another way to look at penalties. If you think of a tax penalty as a "convenience fee" for keeping your money longer (and possibly earning interest), they can seem much less punitive. Some taxpayers prefer this approach.


You can also have a "positive surprise", meaning a large refund. A common reason is your tax advisor (or tax software) instructs you to pay the "safe harbor" amount based on last year's tax liability (generally, either 100% or 110% of the prior year amount, depending on your situation) to avoid penalties. This amount could be much more than this year's liability; thus, unknowingly paying in too much. While almost everyone prefers a refund versus owing more, again, some taxpayers don't like to tie up their money with the IRS. And, with the recent spike in interest rates, "loaning" your cash to the IRS is getting more costly.


In an ideal situation, a taxpayer withholds enough taxes quarterly (or makes estimated payments) to avoid penalties and knows the amount of any additional tax due in April. However, tax obligations can change significantly from year-to-year making perfect foresight difficult (if not impossible). Since managing your taxes well can be time consuming and costly, tax preparers will usually keep calculations simple and conservative to avoid negative surprises. Unfortunately, that may still result in a negative surprise though, to the chagrin of the first type of taxpayer, or a large refund, to the chagrin on the second type of taxpayer.


Wealth advisors, however, are uniquely positioned to help both types of taxpayers manage their tax payments as well as strategically plan for both the near and longer-term. These types of advisors typically have not only experience with and knowledge of taxes, but they manage your financial plan and take a more comprehensive view of your overall financial health. In addition, wealth advisors can coordinate with your tax preparer to ensure accuracy and consistency with their tax filing approach.


Give us a call the next time you're thinking about taxes. We're ready and willing to help.


Setarcos Wealth Advisors LLC ("Setarcos") is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Setarcos and its representatives are properly licensed or exempt from licensure.


The information provided above is for educational and informational purposes only and does not constitute tax advice and it should not be relied upon as such. Setarcos and its advisors do not provide legal, accounting, or tax advice. Consult your attorney or tax professional.






  • Richard Faw

Updated: Nov 30, 2023

The first time I heard Charlie Munger’s name was in the late 90s. I was working at an actuarial consulting firm starting to develop an interest in financial markets and investing and someone said, ‘hey, you should check out Warren Buffett and read his shareholder letters’. I did both. Warren had the spotlight, but he talked about Charlie in every letter. He was hard to ignore. For the next few years, though, he was just a name to me. Warren’s ‘sidekick’ and Berkshire’s vice chairman. I didn’t pay much attention to him. That all changed a few years later.


In the early 2000s, I decided to start attending the Berkshire shareholder’s meeting in Omaha. If you’ve never been or seen clips from the meeting, Warren and Charlie sit side by side at a table in front of thousands of shareholders and answer questions (not provided to them in advance). Warren speaks first (unless the question is directed at Charlie) and then, most often, asks Charlie if he has anything to add.


That was the first time I heard Charlie speak. Warren is brilliant. Charlie might have been smarter. Warren would give long, insightful responses to each question. Charlie, if he offered a response, was brief and answered with piercing insight. His responses were to the point and perfectly reasoned. He would quote Marcus Aurelius in one response and then apply the laws of thermodynamics in another. I was in awe.


After that, I started paying attention to Charlie. I read everything I could from him and about him. I started paying attention to the Daily Journal annual meetings (in which he also answered shareholder questions for hours). I read old transcripts from the Berkshire meetings. And, like my experience reading Warren’s letters, my mind expanded again.


Like so many in this business, Charlie, along with Warren, has been a mentor to me. Odd to say about someone you never met, but at least one definition of a mentor is ‘an experienced and trusted advisor’. That fits.


I’ve learned a ton from Charlie over the years, both about how to be a thoughtful steward of our client’s wealth and about how to make myself a better person. How lucky to have had someone like this in our orbit for so long.


I will miss his wisdom and guidance, but I’m grateful for everything he left behind.

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