Equities represent an ownership stake in a public company. As an asset class Equities are riskier than Bonds, as companies are legally obligated to pay principal and interest to bondholders but are not legally required to pay anything to Equity owners. Furthermore, shareholders are behind bondholders, employers, and suppliers in the event of a bankruptcy. As a result, when a public company goes bankrupt, the company’s equity is wiped out and the investment will go to $0, which has happened with prominent companies such as Enron, Lehman Brothers, General Motors and Worldcom. However, equities also generate much higher returns over time because of these risks.

Historical Returns

Because equities are riskier than bonds, equities have historically generated much stronger returns. The S&P 500 index represents 75-80% of the total market cap of U.S. equities and is a good proxy for the overall U.S. stock market. There is also much better data on the S&P 500 index than the overall U.S. stock market, so we will focus our analysis on the S&P 500. The S&P 500 Index has averaged a total nominal return of 9.6% per year from 1900-2019, and a 6.5% real return after adjusting for 3% annual inflation. That 6.5% real return for the index has been driven by 1.9% real earnings per share (EPS) growth, a 2.8% dividend yield and 1.7% from P/E multiples increasing during that time frame. The chart below summarizes the drivers of S&P 500 returns from 1900-2019.

S&P 500 returns from 1900-2019

Source: Robert Shiller data

Projected returns

To project equity returns over time we’ll need to make estimates for each of the four drivers of returns shown above: inflation, dividend yield, real EPS growth, and changes in valuation (p/e multiples). Below I’ll walk through my assumptions for each of these drivers and give recommendations for how you can think about expected returns for equities going forward. It’s important to note that while all of these drivers of return can fluctuate from year to year, the inflation rate and dividend yield tend to be the most stable, while real EPS growth and changes in P/E multiples tend to be much more volatile as shown in the charts below.


In the U.S. inflation has been below 2% since the Great Financial Crisis. The Federal Reserve has targeted inflation of 2% as part of their mandate for price stability. As a result, I expect U.S. inflation to average 1.5-2%/year going forward. In addition, the bond market expects inflation to be below 2% going forward with the TIPS 5-year breakeven yield at 1.14% and the TIPS 10-year breakeven yield at 1.34% as of 6/29/20. Unless the Federal Reserve revises their 2% inflation targeting regime, I would not expect inflation to exceed 2% on a sustained basis. This contrasts with the historical period above where inflation averaged 3% per year.

U.S. Inflation, 2000-Present

Dividend Yield

5-year and 10-year TIPS breakeven yields

Dividend Yield

Dividend Yield

The dividend yield is a ratio showing how much a company pays out in dividends each year compared to its stock price. So, if a company pays out $2/per share in dividends, and the stock price is $100/share, the dividend yield would be 2%. Over the past 20 years, the dividend yield for the S&P 500 index has averaged around 2%, below the long-term average of 2.8%. Companies have gravitated towards increasing share buybacks rather than increasing dividends as a way of returning cash to shareholders.

Share buybacks are the purchase of a company’s own shares, typically done in the open market, which reduces the number of shares that the company has outstanding. Share buybacks give companies greater financial flexibility than dividends, as investors assume dividend payments will be stable over time, while share buybacks are viewed as an opportunistic return of cash to shareholders. Additionally, share buybacks have tax advantages for investors over dividends. Investors are required to pay income tax on dividends, while buybacks lead to capital gains, which are typically taxed at a lower rate and are only realized when an investment is sold.

As a result, I do expect the dividend yield on the S&P 500 to remain around 2% given investor preference for share buybacks, unless there’s a change in the tax treatment of dividends or a regulatory change that bans share buybacks.

S&P 500 Dividend Yield

Dividend Yield

Real EPS growth

The next major driver of returns for the S&P 500 Index is real EPS growth. From 1900-2019 real EPS growth averaged 1.9% per year but is highly volatile over time as shown in the below charts. Real EPS growth is driven by changes in profit margins and shares outstanding, which are increased when companies issue additional shares and reduced when a company repurchases its own shares. From 2010-2019 annual real EPS growth for the S&P 500 averaged 8.7%, the strongest annual increase for any decade dating back to the 1900’s. This was driven by record profit margins, the impact of the financial crisis, increased share buybacks and strong revenue growth.

  • Impact of the 2008 Financial crisis. The Financial Crisis negatively impacted S&P 500 earnings in 2008 and 2009, leading to real EPS growth of 50% from 2009 to 2010. From 2011-2019, real EPS growth averaged 4.9% per year, which is more representative of recent EPS growth.


  • Revenue growth. Real revenue per share growth averaged 2.65% per year from 2010-2019 and was a large factor in driving EPS growth over that time frame. One of the key factors was continued consolidation across many sectors which allows the remaining companies to charge higher prices for their products as they have fewer competitors.


  • Record Profit margins. S&P 500 profit margins hit all-time highs in late 2018, due to lower corporate tax rates from the Tax Cuts and Jobs Act (TCJA) of 2017 and continued consolidation across many sectors of the economy. Of the 4.9% annual EPS growth from 2010-2019, margin expansion contributed roughly 1.2% per year to EPS growth. The TCJA reduced the top income tax rate for companies from 35% to 21%, leading to higher after-tax earnings across the index. Massive consolidation across many industries was another key driver of record profit margins, as consolidation improves companies bargaining power with employees and suppliers allowing companies to reduce expenses and improve margins. For example, companies typically reduce their employee base following a merger, by consolidating departments such as Human Resources, Information Technology, and Finance and Accounting. However, we are starting to see political backlash against this consolidation, specifically in the tech sector. Companies such as Facebook, Apple, Amazon, and Alphabet (parent of Google), have faced numerous regulatory actions in the U.S., Europe and abroad, and some politicians are calling for the break-up of these large companies. Deconsolidation would be a positive for consumers and employees but would have a negative impact on margins for these companies.


  • Share buybacks. Share buybacks contributed roughly 1% per year to real EPS growth as S&P 500 total shares outstanding declined from roughly 295 million at the end of 2010 to 270 million at the end of 2019.

Going forward, I expect real EPS growth to be closer to the 1.9% average for 1900-2019 and well below the 4.9% average for 2010-2019. Share buybacks should continue to boost EPS growth by 1%, but profit margins will likely decline due to impacts from COVID-19 on the economy. For 2020, S&P 500 EPS is expected to decline 18% from 2019 EPS with revenues declining faster than expenses for many sectors (Oil and Gas, Airlines, Retail, Restaurants, Leisure and Hospitality, Autos, etc.) as a result of COVID-19.

Over the longer-term it is unclear how much of an impact COVID-19 will have on profit margins. As a result, I expect real earnings growth to increase by 1.5-2.5% per year going forward, below what we’ve experienced over the past decade but more in line with historical EPS growth. For earnings to grow well above 2.5% per year, we would need to see a substantial increase in revenue growth or profit margins, which could be driven by technological innovation such as: Artificial Intelligence, Robotics, Renewable Energy, Autonomous Vehicles, or a greater penetration of broadband internet in rural areas.

S&P 500 Annual Real EPS Growth

Dividend Yield

Source: Robert Shiller data


S&P 500 Real EPS Growth by Decade

Dividend Yield

S&P 500 Profit Margin over time

Dividend Yield

Source: Yardeni Research

Price/Earnings (P/E) Multiples

The P/E multiple compares a company’s share price to its earnings per share. For example, if a company’s stock price is $100/share and its earnings are $4/share, then its P/E multiple would be 25x. These multiples allow investors to compare how cheap or expensive a stock is compared to its peers as well as to its historical average, as a tool to determine if a stock could be a good or bad investment. The P/E multiple on the S&P 500 index is currently 21.9x, well above the median of 14.8x since 1873.

Given where the P/E multiple is today, there is a low probability that the P/E multiple increases substantially from here. However, I also don’t expect the P/E multiple to decline towards its long-term average. The reason for this is the fact that interest rates are at historically low levels, which has made equities attractive relative to bonds. Lower interest rates have brought down the required return on equities as an asset class. For example, if previously you required a 10% return on equities when interest rates were at 4%, then you would only require a 6% rate of return on equities with interest rates at 0%.

The first chart below shows the P/E multiple of the S&P 500 index since 1872, and you can see just how volatile P/E multiples can be over time. The second chart below shows the Equity Risk Premium, which is the Earnings/Price of the S&P 500 minus the yield on the 10 Year U.S. Treasury and is useful measure of whether or not equities are attractive compared to Treasuries. As a result, I believe P/E multiples are reasonable levels due to record low interest rates.

S&P 500 P/E Multiple

Dividend Yield

Source: Robert Shiller


Equity Risk Premium

Dividend Yield

Source: Yardeni Research

Why you should invest in International equities

Now that we’ve covered the drivers of returns for equities and made some forecasts around potential drivers of returns, let’ talk about investing in international equities. Why not invest solely in U.S stocks? The U.S. stock market is by far the largest and most liquid stock market in the world, representing 54.5%1 of global market cap as of February 2020.

However, many U.S. based investors have a substantially higher percentage of their equity allocation in U.S. stocks, is that appropriate? The below chart how U.S. based investors can reduce the volatility of their portfolios by investing in non-U.S. equities. The green line represents a portfolio of 100% equities, and the light blue line represents a portfolio that is made up of 60% equities and 40% bonds.2 The sweet spot for reducing volatility in your portfolio is a 40% allocation to to non-U.S. equities. In addition to reduced volatility, International equities have historically outperformed U.S. equities for large portions of time.

Reducing volatility by investing internationally

Dividend Yield

Source: Vanguard and FactSet

Non-U.S. Equities outperform U.S. equities for large portions of time

Dividend Yield


Based on economic and market fundamentals today, I expect U.S. equities to earn a total nominal return of 5-6.5% per year going forward, based on 1.5-2% inflation+2% dividend yield +1.5-2.5% earnings growth, giving us 3.5-4.5% real returns. This assumes the P/E multiple stays constant going forward, which historically has been extremely volatile. Clearly there are many assumptions going into this estimate, so please use the below model to make your own assumptions for equity returns.

While the data above was for the U.S. and S&P 500 Index, you can use this same approach to analyze any country’s equity market by forecasting the key drivers of returns over time. Additionally, U.S. based investors can reduce volatility in their portfolios by allocating up to 40% of their equities to International equities. This can be accomplished inexpensively through an index fund such as VXUS, SCHF or IXUS (disclosure: I am invested in IXUS as of 7/1/20). Similarly, investors can gain access to the entire U.S. stock market through index funds such as VTI, SCHB or ITOT which all charge minimal annual fees of 0.10% or less.

1 https://www.statista.com/statistics/710680/global-stock-markets-by-country/

2 https://institutional.vanguard.com/iam/pdf/ISGGEB.pdf?cbdForceDomain=true

Equity Total Return Projections

Enter percentages as decimals. For example, for 2% enter 0.02.  

Add your own percentages to calculate Nominal Total Return and Real (inflation adjusted) Total Return. Input values, click "Calculate" button for results.

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