Sunday, January 09, 2005


Stockmarket returns over the next 10 years

I continue to be amazed that Wall Street analysts keep saying that they have "trimmed" their expectations for stock market returns for this year and beyond to something around 7 to 8 percent. Well, I have news for them: 7 to 8 percent, while lower than the historic average, is still way too high. Here's why. First of all, let's ask what a sensible rate of return on equities ought to be. Well, here are the facts:

1. A stock's total return is the sum of its dividend yield and its capital gain. If the market's P/E ratio is assumed to stay constant, then the capital gain (the growth in P) is equivlant to the growth in E (earnings per share).

2. The dividend yield is a function of the payout ratio (the fraction of a firm's earnings that is paid out in dividends). Historically, this has averaged about 50 percent, although this number has declined somewhat over the past 2 decades. A reasonable estimate for the dividend yield on stocks for the next 10 years is 2 percent, which is slightly more than the current dividend yield on the S&P.

3. What about capital gains? As mentioned, capital gains are a function of growth in earnings per share (EPS). Corporate profits have tended to average about 10 percent of GDP over the past century. There have been troughs (such as the Great Depression) and peaks. When was the last peak? Well, we're living in it now. Corporate earnings as a percentage of GDP are close to their historic highs. One of the reasons that corporate profits have accelerated is that productivity growth has picked up significantly since the mid-1990's. This has allowed firms to shed excess labor, which has kept wages fairly stagnant. The result: profits have jumped. In the best case scenario, real GDP growth wil contine to be strong, perhaps even rising to 4 percent over the next decade.

5. What does this imply for growth in earnings per share? Well, clearly EPS will not grow as quickly as GDP since new firms will enter the market and hence, aggregate U.S. earnings will end up being split among more firms. Also, existing firms will continue to issue new shares, thereby partly diluting existing shareholders. Historically, these two factors have implied that EPS growth has been about 2 percent lower than GDP growth. However, if corporate profits as a percent of GDP decline over the next 10 years towards their historic averge, EPS growth will lag GDP growth by more than 2 percent.

6. The market P/E is about 20 right now. The historic average is 16. Thus, if valuations decline to their historic average, the P in the P/E will grow less quickly than the E.

7. Now let's put it all together: If profits as a share of GDP stay the same and valuations do not fall, this implies that real EPS growth will be 2 percent (4 percent real GDP growth minus the 2 percent wedge between EPS and aggregate profit growth). This yields a total real return of 4 percent (2 percent dividend yield plus 2 percent capital gains). So in the case scenario, stock prices will grow by 4 percent in real terms over the next 10 years. Assuming inflation stays at around 2 percent, that's 6 percent nominal growth in stock prices. Again, this is the best case scenario. What's a "realistic scenario"? Well, a realistic scenario is one in which the market's P/E ratio declines to its historic average of 16 and corporate profits as a percent of GDP decline by about 2 percent. Taken together, this lowers expected stock returns by 4 percent per year to about 2 percent per year. And that, of course, still implies that the economy will growth at an above average pace, which is far from certain.

The bottom line is that Wall Street's "conservative" estimate of 7 to 8 percent growth in stock prices is not nearly conservative enough. In the current market environment, 2 percent is about the best bet that one can make. As Warren Buffet once said, if stock returns came from history books, librarians would all be millionaires. The fact of the matter is that historic returns have been colored by the fact that analysts have confused apples with oranges. In the late nineteenth centruy, the market's P/E was less about 5 because stocks were perceived then to be very risky, reflecting much worse corporate governance, high transaction costs, and fewer ways to diversify one's portfolio. Furthermore, the 1970's and early 80's witnessed very high inflation, which artificially boosted nominal equity returns (but not real equtiy returns). This accounts for why historically, stock market returns have averaged about 8 percent. However, future returns are likely to be a lot lower.

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