An extraordinary decade for markets

The long-awaited pivot away from US equities may finally be at hand, and India may benefit from this shift

The 10 years ending December 31, 2021 were quite extraordinary for big technology companies and the US markets in particular. Now that we are in the midst of a bear phase, there are multiple reports and analyses dissecting the returns of the last decade, and trying to forecast what the realistic expectations for financial market returns would be in the coming years.

It has been clear for some time that following the global financial crisis (GFC), the US equity markets have been the only place to be. They have outperformed international markets in 10 out of the last 12 years since the markets bottomed in March 2009. US stocks have delivered an outperformance of over 800 basis points

(8 per cent) annualised over this 12-year period, quite extraordinary, and a reversal of the performance trends in the decade preceding the GFC.

Even in absolute terms for the decade just ended (December 2021), US equities (S&P500) delivered a total return of 16.6 per cent per annum. This was the fourth best trailing 10-year returns in US stock market history. Only the 10-year series ending in 1998, 1999 and 1958 delivered better returns. So, we have just lived through an extraordinary decade for US returns. It is highly unlikely that this magnitude of returns will be repeated soon. It is interesting to dissect this 16.6 per cent annualised return. What were its components and drivers?

A noteworthy analysis has been done by Christopher Bloomstran in his annual letter. He breaks down the returns into sales/share growth (a combination of absolute sales growth and share count change), margin growth, price/earnings multiple change, and finally dividend yields.

The 16.6 per cent return for the last decade for the S&P 500 breaks down as follows: 3.8 per cent comes from sales per share growth; 4 per cent came from post-tax margin, rising from 9.2 per cent on December 31, 2011 to 13.4 per cent for the year ending December 2021; 6.4 per cent came from the P/E multiple expanding from 13.3 to 23.6; and then the final 2.4 per cent of the return came from dividend yields. These four components add up to 16.6 per cent annualised returns over the last decade. Multiple expansion, driven by record low interest rates, was the biggest driver of the return.

Interestingly, the companies in the S&P 500 only delivered absolute sales growth of 3 per cent per annum over the last decade, a much lower number than I would have intuitively thought. Sales/share growth bumped up by 0.7 per cent to 3.8 per cent due to buybacks as corporate America in total shrank its share count by 7 per cent over the last decade. This mediocre sales growth then gets levered into earnings per share (EPS) growth of 7.8 per cent per annum over the decade due to margin expansion. Post-tax margins of 13.4 per cent for the S&P 500 are at all-time highs. This margin surge is partly due to the cut in corporate taxes to 21 per cent, record low rates and the loss of bargaining power of labour. Just for context, in the tech bubble of 1999-2000, corporate profit margins peaked at 8 per cent. We are far from there! Margins, far from regressing to the mean, have broken out into uncharted territory over the last decade.

The 7.8 per cent EPS growth then gets further levered up by multiple expansion, as P/E multiples rose from 13.3 to 23.6. Multiple expansion adds 6.4 per cent to annual decadal returns taking it to 14.2 per cent. The final 2.4 per cent comes from dividends.

What becomes clear when looking at this decomposition and for other periods of high returns is that US stocks cannot deliver 10 per cent or higher total returns today unless the P/E multiple and margin expand. Sales/share growth will be unlikely to exceed 4-5 per cent, given the base of almost $13 trillion of sales for the S&P 500. Even in the decade ending December 1999, when markets delivered trailing 10-year returns of 18.2 per cent, 11.4 per cent of this came from margin and multiple expansion. Even in this decade sales/share growth was only 4 per cent.

Illustration: Binay Sinha

What is interesting is that the top five technology stocks (Apple, Microsoft, Alphabet, Amazon and Meta) delivered an annualised return of 30 per cent over the decade. It would have been impossible to keep up with the markets in the absence of holding these stocks in size. These five stocks delivered their returns largely on the back of sales growth, delivering sales/share growth of 20 per cent (17.2 per cent absolute sales growth and the balance through share count reduction of 21 per cent over the decade). The sales growth was levered up by multiple expansion, as P/Es expanded from 13.4 to 33.4. There was a marginal contribution from dividends of 0.5 per cent which was more or less offset by a slight margin decline for the group of  five. Thus, the 30 per cent returns for this group came 20 per cent from sales/share growth and the balance 10 per cent from multiple expansion.

When using the above template to look at prospective returns over the coming decade, things look difficult. Even if you assume absolute sales can grow faster than the last decade’s 3 per cent, given the size of the US economy and the expectation of an upcoming recession and generally slower global growth, it is unlikely to be much faster than 4 per cent, unless inflation remains elevated through the whole decade. We have already seen markets decline by 21.5 per cent this year, despite that, multiples and margins remain elevated. The correction has largely happened in the multiple, margins have not reduced from peak levels. Assuming no further expansion or decline in both margins and multiples, from here we can hope to get the 4 per cent sales growth, add another 0.5 per cent for share count reduction and 1.2 per cent for dividend yields, leading to approximately 5.5 per cent as the total return stream for the S&P 500 in the coming decade. A far cry from 16.6 per cent.

However, if one were to assume at least a partial normalisation of both multiples and margins to 15.5 and 10 per cent, the S&P500 will deliver somewhere around 3 per cent per annum in total returns over the whole decade even after the decline we have already experienced.

This is important from multiple angles. If this is the return profile for stocks in the US, buying corporate bonds yielding 8-10 per cent in dollars does not look that bad.

Looking at data from 1971, whenever US markets have delivered rolling 10-year returns of less than 6 per cent, international stocks have outperformed 94 per cent of the time. The long-awaited pivot away from US equities may finally be at hand. The setup looks right now. If money leaves US equities, emerging markets (EMs) will get its share. Within EM, India now has the second highest weight. We will get our share of flows. In any snap-back for the EM asset class, India may initially underperform, given relative valuations, but it is now too big within the asset class to be ignored. If foreign buying goes from a headwind to a tailwind, combined with the domestic flows, technically the markets will be on a strong footing.

For India, while our multiples are undoubtedly not cheap, there is scope for margin expansion as corporate India goes into a capex cycle and consumption and exports grow. We are still not near peak margins. As long as we can maintain capital discipline and not keep diluting, the sales/share growth should be strong and in double-digits, which can be levered up by some margin growth. As long as multiples do not collapse, returns should be fine, even assuming the above framework. We can hit double-digit returns, with very limited margin expansion and low dividend yields as long as multiple compression does not prove to be too much of a drag.
 

The writer is with Amansa Capital