The S&P 500: Just Say No

Pension Trustee Smith: I recommend to the committee that we liquidate our International equity assets and index our equity exposure to the S&P 500. US stocks have outperformed for the last 20 years, and I see no reason why that should not continue. Everyone knows that the US is the strongest economy and market in the world.

This is a somewhat fictionalized version of a comment or conversation that has gone on in many committee discussions over the last several years in one form or another. And why wouldn’t it? Being a US equity investor over the past several years has felt glorious. The S&P 500 has trounced the competition provided by other major developed and emerging equity markets. Over the last 7 years, the S&P is up 173% (15% annualized in nominal terms) versus MSCI EAFE (in USD terms), which is up 71% (8% annualized), and poor MSCI Emerging, which is up only 30% (4% annualized). Every dollar invested in the S&P has compounded into $2.72 versus MSCI EAFE’s $1.70 and MSCI Emerging’s $1.30. Diversification theoretically sounds good, but as Yogi Berra said, “In theory there is no difference between theory and practice, in practice there is.” Diversification in this particular instance seems good in theory but not so much in practice.

So, shouldn’t we agree with Trustee Smith and throw in the towel, index all of our equity exposure to the S&P 500, and call it a day? If our goal is compounding capital for the long term, which it is, we would not just say “No,” but something akin to “Hell no!”

Valuation of the S&P 500
The bedrock of everything we do is valuation, so let’s begin addressing Trustee Smith’s concerns with a look at the current valuation of the S&P 500. We will start our tour of valuation by examining our own framework. This in turn starts by understanding the drivers of return.

For any equity market, the return achieved can be broken down into four component parts. In the long term, the return is almost exclusively driven by dividends (growth and yield). Equity owners need to be compensated for providing capital to companies to help fund their long-term investments. That compensation comes from the cash flows the companies generate from their risky investments via earnings and dividends.

The two other ways to make money from owning an equity asset class are from multiple (P/E) or margin expansion (collectively we call these elements the valuation components). Together these four components make an identity – we can (ex post) always decompose returns into these factors. In Exhibit 1, we show a return decomposition for the S&P 500 since 1970 based on these four factors (earnings, dividends, margins, and P/Es). Margins and P/Es are basically flat over this very long time period. As we stated above, over the long term, the returns achieved have been delivered largely by dividends.