Can the US stock market replicate the bull market of the past decade in the future? It's difficult, but there is a chance!

The US stock market has performed strongly over the past decade, bringing substantial returns to long-term holders and outperforming almost all other asset classes. However, because these returns have been so significant, simple mathematical calculations show that replicating the past decade's performance would require a near-miraculous growth in both earnings and valuations, regardless of how strong the performance is in the 2020s.

Figure 1

Zhitong App has learned that this mathematical calculation comes from Jordan Brooks, a senior executive at AQR Capital Management. He analyzed the driving factors of the market, which have delivered nearly 12% growth each year since 2013, adjusted for inflation and cash rates. Given the current high starting point of stocks, he concluded that even generating average returns would be quite challenging.

Brooks said, "To witness a replay of the stock market's performance over the past decade, the stars must align (a perfect combination of various favorable factors). After a long period of outstanding performance, valuations are usually high, which leads to weaker expected returns in the future."

The quantitative analyst found that the market has been performing like a cash register since the global financial crisis, and this year is no exception, with the S&P 500 index surging 24% and the tech-heavy Nasdaq 100 index skyrocketing nearly 54%, marking the best annual gain since the late 1990s dot-com bubble. Although there is no numerical barrier to prevent stocks from continuing to rise, mathematical calculations reveal the challenges within the current valuations.

It is understood that Brooks' analysis focuses on the ten-year period ending in June of this year, but his findings still hold true for the market, which has increased by an additional 7% since then. The calculated annual return of the S&P 500 index, after deducting Treasury yields, was 11.9% for the past decade, outperforming all assets, from non-US developed market stocks to commodities to complex quantitative strategies.

It is worth mentioning that the S&P 500 index's gains in 2023 defied the expectations of skeptical forecasters on Wall Street and a large number of investors who adopted defensive strategies. The end of the historic tightening cycle by the Federal Reserve sparked optimism about avoiding a recession and triggered significant gains in everything from speculative tech stocks to junk bonds.

Brooks believes that the problem facing the stock market bulls is the valuations after a decade of expansion. Calculated using cyclically adjusted price-to-earnings ratios, which smooth out earnings fluctuations by using the average returns of the past ten years, the S&P 500 index is trading at over 30 times earnings, one of the highest readings on record.

By definition, stocks can appreciate by achieving one of three conditions: earnings growth, valuation expansion, or dividend increases. Brooks' view is simple: replicating the returns of the past decade would require significant growth in both the first and second components.He calculated that even if the actual returns grow at a relatively relaxed rate of 4.5% per year, the cyclic price-to-earnings ratio of the S&P 500 index would need to reach an unprecedented 55 times in the next ten years.

Figure 2

In addition, Michael Orlofsky, Chief Market Strategist at JonesTrading, noted an additional complicating factor: the era of near-zero benchmark interest rates has come to an end.

Orlofsky said, "There has been significant valuation expansion under massive monetary policy stimulus. I don't think the situation of the past decade will repeat itself. The economy is undergoing structural changes, which may not be as favorable."

Of course, American companies' profit machines have repeatedly generated earnings that exceed expectations. So, if this situation continues, it won't be surprising. But even under the expansion rate at historical highs, the pressure on valuations is daunting.

If actual returns grow at a rate of 6% per year, which is the growth rate seen in 90% of the past 70 years, the cyclic price-to-earnings ratio would need to reach 50 times to match the returns of the past decade. According to Brooks' calculations, this would exceed the peak during the dot-com bubble.

He wrote, "Even under the most extreme actual earnings scenario, stock market valuations would need to reach unprecedented heights."

Finally, in the current market's frenzy over artificial intelligence and the end of the Federal Reserve's tightening, analysts see soaring earnings. According to data, the market expects profit growth of 11% in 2024 and 12% in 2025. But such growth is rare. The last time US stocks achieved double-digit growth for two consecutive years (i.e., 2017 and 2018) was a long time ago.

Matt Maley, Chief Market Strategist at Miller Tabak + Co, said, "The market's valuation is very high, prices are perfect. This year, the market cannot rely on valuation expansion. It must see growth that contributes to the 'E' part of the 'P/E' ratio rising meaningfully."

Figure 3

Overall, this year serves as a reminder to many that excessive caution can come at a high cost. According to data cited by Bank of America, cautious investors missed out on this year's surge, with money market funds attracting $1.3 trillion in inflows, dwarfing the over $150 billion flowing into global stocks. The seven largest stocks have soared over 100% this year.One of them, NVIDIA (NVDA.US) - the manufacturer of chips for artificial intelligence - has seen its stock price more than triple.

For Brooks, the next stage is even more challenging. The AI boom must be translated into historic actual revenue growth or incentivize investors to pay higher prices for returns than ever before.

He said, "One may be very optimistic about the profitability of AI for businesses," but still mentioned that the stock market is unlikely to replicate the performance of the past decade."