BofA says stock valuations signal negative annual returns over the next decade — and recommends rotating into an alternative index

It could be a brutal decade ahead for stocks, according to a valuation signal used by Bank of America.

In a September 14 client note, the bank said that the S&P 500‘s normalized price-to-earnings ratio — which compares stock prices to average earnings over multiple years — currently sits at 32. That level implies that the index will deliver an average annual return of -3% over the coming decade.

A better way to gain exposure to the market over the next 10 years, the bank said, is the S&P 500 equal-weighted index.

It has a normalized PE ratio of 25, which implies +3% annualized returns in the decade ahead.

The valuation is remarkably accurate at forecasting long-term returns. Over a 10-year period, it can explain around 80% of the S&P 500’s returns.

The normalized PE ratio is one of 10 valuation gauges Bank of America tracks. Six others on the list — including the Shiller PE ratio, price-to-book value, and market cap-to-GDP — also imply negative returns for the S&P 500 by 2036.

The S&P 500’s average implied return from all 10 signals is -1.4%.

Despite highlighting the warning signals, the bank said that the cap-weighted index could be more resilient than valuations imply, saying that “projected returns based on historical valuations may be too punitive.”

That’s due to factors like stocks’ tendency to outperform bonds in stagflationary environments, and the high quality level of S&P 500 companies today, with low debt levels and stable earnings.

Still, the bank said it prefers the equal-weighted index given its cheaper valuation levels.

The Invesco S&P 500 Equal Weight ETF (RSP) offers exposure to the alternative index.