The coronavirus crisis now looks like a 6-month blip in a broadly sustained U.S. bull market stretching all the way back to 2009. However, there is a catch. It’s the market’s valuation. Over the very long term, say decades, the market can be expected to rise in line with earnings growth. However, over just a few years that virtually never happens. Swings in valuations dominate.

That’s what we’ve seen over the past decade. Back in 2009 investors in the aftermath of the financial crisis, investors could pay $15 for $1 of earnings from the S&P 500, or a P/E of 15x. Now the market demands closer to $40 for that same $1 of earnings. That explains a lot of the broad bull market. Roughly speaking, two thirds of stock returns over the past decade are due to multiple expansion, the remaining third is earnings growth.

Looking forward, a few things could happen. Maybe we could see a similar outlook for the next decade with multiples expanding at the same rate. The problem is then you’d be paying over $100 for a dollar of earnings. That’s not impossible. Yet, in historical terms its extremely unlikely to be sustained. We’re currently at around the highest multiples we’ve seen historically for any period of time. So the chances of multiple expansion continuing unbated are slim.

A second scenario then, is that the multiple stays the same and we’re just left with earnings growth alone. That’s not bad, stocks return around 7% or so in that scenario if history is any guide. It’s a respectable return. That’s not common either, stock valuations are seldom static for any period of time.

The final scenario is the problem. In fact, it’s a big problem. Pick a long-term average multiple of say paying $10 or $20 for a dollar of earnings, and assume we go back to that. Over, say the next decade, based on factors like declining margins, rising inflation, sluggish growth or just investors becoming more pessimistic. Now, even if earnings are chugging along at 7% growth you still aren’t making money in stocks. If the multiple halves from 40 to 20 that can wipe out a decade of earnings growth. If it falls from 40 to 10 then the market could halve, despite earnings growth.

This has been a relatively long run for stocks and like Q1 2020 there have been considerable bumps along the way. However, the future outlook is challenging. The sort of environment that leads to healthy returns from here for stocks are historically less common based on these valuation levels. In contrast, should valuations compress, stock investors may be in trouble. Plus with meagre yields, bonds may not offer much of a safe haven either.

The big challenge though, is that even though these sort of forecasts are quite informative on a multi-year view (say 5-7 years) they are less useful in the short-term. So there are reasons to be cautious on stocks on a medium-term view, but that doesn’t necessarily help us for the shorter term.

Furthermore, its a general problem, nothing looks especially cheap. Not stocks, not bonds, not housing and not most commodities. So stocks might be set for weaker returns over the come years, but where to put your money should that occur is a less simple question.

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