For historical perspective, the chart below presents the 7-year projected total returns obtained in this manner in blue. The actual subsequent 7-year total return for the S&P 500 is depicted in green. Notice that the performance of this method deteriorated significantly after about 1988, reflecting the fact that terminal yields 7 years later began to depart dramatically from prior historical norms.
In order to understand the departure of that green line (actual 7-year returns) from the blue line (expected 7-year returns), it is important to recognize the effect of bubble valuations in the period since the mid-1990's. One way to understand this impact is to ask the counterfactual question: what would the actual returns of the S&P 500 been if the dividend yield had not broken below the 2.65% level that defined past historical market peaks?
The answer to that question is depicted below by the red line. It presents actual historical 7-year S&P 500 total returns with one restriction. For 7-year periods that ended at a dividend yield of less than 2.65%, the red line presents what the 7-year return would have been if the terminal yield was limited to a 2.65 lower bound.
The difference between the green line and the red line represents the effect of bubble valuations. Had it not been for a period of sustained bubble valuations (which ultimately proved themselves to be bubble valuations by creating a 13 year period of dismal subsequent returns), we find that the yield-based model above would have extended its admirable historical record.
This creates a terrible problem for investors here. Given that the yield on the S&P 500 is now below 2%, it is essential for investors to recognize that they now rely on the achievement and maintenance of sustained bubble valuations in the years ahead. Unless investors believe that bubble valuations can be maintained indefinitely, they can expect little but abysmal returns over the coming 5- 7 year period.
