Summary

The VTI is likely to underperform inflation over the next decade leaving holders no better off in real terms by the year 2032.

Historically, investors who bought U.S. stocks at similar PE valuations as the VTI currently could expect to see long-term real returns of around 2-3% annually.

However, profit margin mean reversion and weaker real GDP growth suggest that future returns will be far lower than this.

The good news is that passive investors do not have to settle for such meager returns as there are several overseas markets that offer much stronger prospects.

I last wrote about the Vanguard Total Stock Market ETF (NYSEARCA:VTI) back in May 2021 when I argued that the market was in a '3-sigma' bubble and that rising inflation threatened to be the pin to burst it (see ‘VTI: Rising Inflation May Burst This 3-Sigma Bubble’). While the VTI went on to rise a further 13% to its December peak, it has since given back all its gains, including the impact of dividend payments. It may pain passive investors to learn that even after the recent decline the VTI is likely to underperform inflation over the next decade leaving holders no better off in real terms by the year 2032 and subjecting them to significant volatility in the coming years.

The VTI ETF

The VTI tracks the performance of the CRSP U.S. Total Market Index which measures the total investable U.S. equities market. While the ETF has a similar composition as the SPY, it also included small- and mid-cap companies, and the underlying index has a larger market capitalization of USD44trn versus the S&P500’s USD36trn. The VTI trades at even more extreme valuations relative to the S&P500, while paying an even lower dividend yield.

The VTI is a popular ETF among buy-and-hold investors as it captures the entire U.S. market and charges an expense ratio of just 0.03% per year. The VTI is a favored market for followers of the Jack Bogle philosophy that 'time in the market beats timing the market'. While this is a good rule of thumb to invest by for most people most of the time, it does not tell the full story. There appears to be a large gap between the returns that passive investors expect to achieve over the long term and the returns that are likely based on current valuations. For those disciplined investors who are committed to dollar cost averaging as stock valuations fall, this may not be a problem, but this is easier said than done. There is an overwhelming urge to sell during bear markets as the red ink piles up, and this is particularly the case if stock weakness occurs amid economic weakness and job security declines.

Valuations Are Still Extreme

The VTI's valuations have fallen somewhat since last year's peak, driven by a fall in equity prices and a rise in earnings. The trailing PE ratio now sits at 22x. The forward PE ratio (based on expectations of earnings over the next 12 months) sits at 18.9x, which may seem reasonable, particularly relative to the 2020 peak of 29.9x. Historically, investors who bought U.S. stocks at similar PE valuations could expect to see long-term real returns of around 2-3% annually. Considering the long-term average is around 6%, this is already low, but there are two reasons that suggests future returns are likely to be much lower than this, and quite likely negative.