Should You Invest Only in the S&P 500?

Greetings!

There are two main investing questions we aim to tackle for this month's newsletter:

1. Can you predict what the stock market will do? 2. Should I just own a S&P 500 index fund?

#1 Can you predict what the stock market will do?

"Those who have knowledge, don't predict. Those who predict, don't have knowledge."

While I don't prescribe to making predictions, we do have nearly 100 years of market data to use as a guide.

Some research has been done that takes into account current market valuations versus company earnings to forecast the expected return over the next 10 years.

This is called the Shiller CAPE 10. The name doesn't really matter nor do I need to fully type out the intricacies of the Shiller CAPE 10.

The main thing to know is: The lower the CAPE 10 the better the forward 10 yr returns were. The higher the CAPE 10, the worst the forward 10 yr returns were, ON AVERAGE (key point).

We can look back at the historical data to see how accurate this formula has been for predicting returns.

For example, when the CAPE 10 was below 9.6 - the 10 yr forward returns averaged 9.8% - after inflation.

When the CAPE 10 was between 16.1 - 17.8, the 10 yr forward return averaged 5.4%, after inflation.

When the CAPE 10 was above 26.4, the 10 yr forward return averaged 0.9%, after inflation

As we entered into 2024, the CAPE 10 is above 32.

All that being said, it's extremely important to understand that regardless of where the CAPE 10 is a wide array of outcomes are possible. Meaning - a high CAPE 10 number doesn't necessarily mean a poor outcome and vise versa.

As we've seen last year in 2023, the markets did very well despite a high CAPE 10 number.

This is why it's important to run a Monte Carlo analysis vs a straight line average return projection when considering one's financial plan.

A Monte Carlo will simulate thousands of scenarios that have existed prior, which allows you to test the durability of your plan.

You can then see your odds of success through a wide range of varying times through history.

#2 Should I just own a S&P 500 index fund?

While I am not making any predictions, given the current high valuations of the S&P 500, it would not be wise to just own a S&P 500 fund.

Even if we were at low valuations for the S&P 500 I still would not suggest owning only 1 fund. The S&P 500 gives you exposure to 500 of the largest companies in the US. It is a common index that invests in companies you'll likely recognize like Apple, Tesla, Google, etc.

While 500 companies may seem like a lot and give you plenty of diversification, it's important to understand the risk of only investing in the S&P 500.

To illustrate this, from 2000 - 2010, the S&P 500 delivered a total return of 7% over that 10 year period. NOT an average of 7%, a TOTAL of 7%.

The Russell 3000 index, the largest 3000 US companies, delivered a total return of 17% over this same time period. Not great either, but still better.

The S&P Small-cap 600 index, measures 600 of smaller size companies in the US, delivered a total return of 99% over this same time period.

Now we can certainly cherry pick data that shows time frames in history where the S&P 500 did outperform other asset classes but the point is going all in on 1 singular asset class is never a good idea.

So what should we do with this information?

You can consider owning a globally diversified portfolio by investing across several asset classes to begin with vs just sticking with the S&P 500.

International Markets

Compared to the US which had a CAPE 10 of 32 heading into 2024 (remember the higher the CAPE 10, the lower expected returns), developed international companies have a CAPE 10 of around 18 (the lower the CAPE 10, the higher expected returns).

Emerging Markets currently have a CAPE 10 of 13.

Small & Value Stocks

Value and Small size companies are also trading at relatively low levels compared to growth stocks.

As we saw above, Small sized companies performed relatively well from 2000 - 2010 compared to the S&P 500: Small 99% total return vs S&P 500 7% total return.

Interestingly enough, the S&P 500 CAPE 10 was near an all time high in January 2000 at a value of 42.

Alternative Investments

Another way to diversify is through the use of Alternative Investments. Alternative investments could include private equity, private debt, real estate, reinsurance, etc

While adding alternatives can be a viable strategy, the research shows that most alternative strategies have fallen short of delivering high returns, particularly once the tax, costs, and in some strategies the potential headaches are factored in such as direct ownership of real estate.

In general, there are two key features to look for in alternatives

Low correlation to the stock markets (ideally uncorrelated to the stock market) - meaning if the stock market goes down, the alternative strategy shouldn't mimic that same decline

After factoring in taxes/expenses, expected returns are somewhere between the returns expected from fixed income (bonds, treasuries, money markets, etc) and the stock market.

Investors, and Advisors, set themselves up for failure if they position an alternative strategy as likely to have a higher long-term return than a globally diversified stock portfolio. While that can be the case, it is not a reasonable expectation for the vast majority of alternative strategies.

Key Points While we shouldn't base our financial plan on one particular formula for expected returns, we can use these tools to better understand where we are today in comparison to where we've been historically

The S&P 500, while historically has performed very well, can also go through extended periods of poor performance.

One should consider diversifying to mitigate the risk of certain asset classes that may perform poorly during an important period of your investment timeline.