This current rally is a genuine bull market, CIO sees several reasons that equity returns will be below average in coming years. (ddp)

As of the time of writing, the S&P 500 is more than 20% above its closing price low from last October—meeting the common definition of a bull market.

Only in hindsight will we know if this rally is truly the end of the bear market. Keep in mind that since World War II, there have been four instances of gains of more than 20% within a bear market that proved ephemeral: 1947, 2001, 2002, and 2008. In these episodes, stocks subsequently sold off and made new bear market lows.

But whether this current rally is a genuine bull market, we see several reasons that equity returns will be below average in coming years.

Earnings have been resilient, leaving less room to rebound strongly in the event of a soft landing. Despite all the concerns about S&P 500 profits, they are slightly above the long-term trend of 7% annual earnings per share growth since 1960. This is in contrast to most bear market low points, when earnings were depressed, creating plenty of scope for a sharp turnaround.

Valuations look demanding. There are many ways to measure valuations. Right now, the forward price-earnings ratio for the S&P 500 based on bottom-up consensus estimates is 18.8 times. This is high relative to the average of 15.4 times since 1985. But we can also use the trend earnings concept to gauge valuations. Currently, the S&P 500 is trading at more than 21x trend earnings, which is elevated compared to history. If October was indeed the low point in this cycle, it would mark the highest multiple for a bear-market bottom in the last 60-plus years.

Historically, such valuations have set the stage for below-average equity returns. Data going back to 1960 illustrate that annualized returns tend to be weaker when the trailing 12-month trend price-earnings ratio is elevated. Based on current valuations, annualized returns in the mid-single digits look plausible over the next 10 years—below the long-term average annualized gain of 10% since 1960.

So, given the starting point for earnings and valuations, forward returns for large-cap stocks will likely be below normal over the next decade. For long-term investors, we suggest looking beyond the debate about whether the current environment is a bull market or not. Instead, investors should make a realistic assessment of the long-term opportunity given the current set up. One way to supplement potentially weaker returns from public equity markets would be to add to private market exposure. Data going back to 1993 show that private equity pooled-returns have consistently outperformed the MSCI All Country World index. However, investors need to be able to tolerate lower liquidity on this portion of their portfolios.

Main contributors - Solita Marcelli, Mark Haefele, David Lefkowitz, Christopher Swann, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - How strong will be the bull market be?, 20 June 2023.