Why your favorite S&P 500 index funds are in for a decade from hell

• Current high valuations suggest poor returns for the S&P 500 over the next decade.
• The Shiller CAPE ratio predicts low annualized returns of around 3% over the next decade.
• Experts like Michael Finke and John Hussman highlight the risks of investing at peak valuations.

It's investing advice that you've probably heard over and over again: buy an index fund, don't touch it, and watch your nest egg grow.

And for good reason. History has proven this to be a brilliant strategy if investors are willing to hold for the long term. For example, $100 invested in the S&P 500 in 1990 would be worth $3,220 today. Returns on index funds tracking major indexes have been so good while requiring minimal effort that they're where investing legend Warren Buffett tells most people to put their money.

Odds are this approach will continue to succeed over a multi-decade period. This is even more the case for investors who dollar-cost-average, or buy in increments over a long period of time, during ups and downs in the market.

But evidence shows that it's an utterly terrible time to buy into the broader market, especially for investors looking to hold for around a decade.

That's a bold statement, considering the S&P 500 is up 25% over the last year.

But that's just it. The market has gotten so frothy in terms of valuation that it's setting itself up for abysmal returns over the next 10 or so years. That's what the numbers say, at least.

Valuations measure how expensive stocks are relative to history. One of the most common gauges is the 12-month forward price-to-earnings ratio, which considers the price of a stock or the overall market relative to near-term earnings expectations. There's also the price-to-earnings-to-growth ratio (PEG), which considers longer-term growth prospects.

But for determining long-term returns, other metrics prove to be more trustworthy when it comes to determining how stocks will perform in the long run.

Take the Shiller cyclically-adjusted price-to-earnings ratio (CAPE), which is a 10-year rolling average of the 12-month trailing PE ratio. This normalizes the measure by smoothing out outlier data.

According to an analysis by Michael Finke, a professor of wealth management at The American College of Financial Services, the CAPE ratio has a remarkable ability to predict future returns. In 2020, Finke ran a regression analysis, a statistical test that aims to identify the impact that certain variables have on a given outcome, and found that between 1995 and 2010, CAPE ratio levels at any point in time explained 90% of the S&P 500's returns over the following decade.

The relationship between the CAPE ratio and future returns bodes poorly for the 10 years ahead. The S&P 500's current CAPE ratio is 35.7, trailing only 1999 and 2021 levels and sitting above the heights reached in the 1929 bubble. A level of 35.7 puts estimated annualized returns over the next decade at around 3%.

While that may not sound so bad, the benchmark index has doled out 10.9% annualized returns since 2008. Plus, 10-year Treasury notes offer a risk-free annualized yield of 3.89%.

When Finke published his report, John Rekenthaler, a vice president of research at Morningstar, marveled at the findings.

"Have you ever seen such a tight fit between a stock-market signal and future performance? If so, let me know, because I cannot think of such an example," Rekenthaler wrote in July 2020. "I believed that Finke's work was accurate given his background, as well as the reputation of the website that published the article, but I confess that I did not fully believe those numbers until I ran them myself."

Enter John Hussman. Hussman, the president of the Hussman Investment Trust, is a so-called perma-bear who is seemingly always pessimistic about the outlook for stocks. While it can be easy to ignore these types, his data is difficult to argue with.

Hussman's favorite valuation measure is the total market cap of non-financial stocks-to-gross value added of those stocks — essentially a price-to-revenue ratio for real economy companies.

Like the CAPE ratio, it has an uncanny ability to predict where the market will go in the long term. And the more extreme the starting valuation, the better its predictive ability over the following 12 years seems to get.

As the arrow in the chart above shows, mid-July levels of the metric put the predicted annualized S&P 500 returns at -6% over the next 12 years.

Here's the measure, which recently hit all-time highs.

Hussman often writes that high starting valuation levels lead to "long and interesting trips to nowhere," which the market rolling through economic cycles over the following 12 years. For example, the S&P 500 was still lower at the start of 2012 than it was at the start of 2000, at the height of the dot-com bubble. Meanwhile, investing at post-bubble lows in 2002 would meant more than 50% upside to the start of 2012.

To reiterate, these gauges offer an outlook for the overall S&P 500 over a specific timeframe of 10 or 12 years. Valuations don't matter as much in the short term. Here's a 2021 Bank of America chart showing the impact that starting valuations have on subsequent returns in each of the following 12 years.

Case-in-point, levels for both of the above valuation metrics were historically elevated a few years ago, yet the S&P 500 is up 47% since the start of 2021.

Similarly, if you're in your 20s or 30s and don't plan on touching your stock market assets for decades to come, data shows this doesn't apply as much.

But according to the numbers through the decades, there's little doubt that starting valuations impact future returns in the long term. And if you plan on pulling your money out of the market in around 10 years, now may not be the best time to buy in.