Low Return Environment?

Michael L. Gay, MBA, CFP®

John Bogle (of Vanguard fame) has a nice, simple model for explaining stock market returns. In his model, market returns can be attributed to three factors:

1. Earnings Growth
2. Dividends
3. Changes in the P/E ( Price/Earnings) Ratio

According to Bogle, the stock market has earned an average annual return of about 9.6% during the past century. That return included earnings growth of 5%, dividends of 4.5%, and a slight increase in the P/E ratio which accounted for the remaining 0.1%.

The question, of course, is whether or not that 9.6% historical average is likely to hold for the foreseeable future. While I’d be willing to bet that the next century will see similar average returns, I’m not willing to bet that the next decade will be quite so rosy. I hope I’m wrong, of course, but each of the three variables appears to be subject to some very strong headwinds that are likely to result in lower-than-average returns for the foreseeable future.

Earnings Growth. Globally, earnings growth is likely to be muted for quite some time as the developed economies attempt to work through the recent financial crises. As Bill Gross noted in an article entitled “You Don’t Get the New Normal”, investors need to learn to expect “half-size economic growth induced by deleveraging, reregulation, and deglobalization. People, companies and countries shedding their debts (will lead to) years of slow economic growth and meager investment returns.”

Dividends. Dividends historically have accounted for a large percentage of stock returns. Unfortunately, dividend yields have been steadily declining. In the early part of the 20th century, dividend yields approached 6%. In the latter part of the 20th century, dividend yields declined to less than 3%. And, as of this writing, dividend yields are averaging around 2%.

P/E Ratios. The P/E Ratio accounts for what Bogle calls the “speculative” component of stock returns. It represents the price that investors are willing to pay for a dollar of earnings. Historically, the P/E ratio has averaged about 15 times earnings. In other words, if a company earns $1 per share, investors have been willing to pay about $15 for that company’s stock.

During periods of market optimism P/E ratios tend to rise as investors become willing to pay more for a dollar of earnings. During periods of market pessimism, P/E ratios tend to fall as investors flee the market.

Currently, the P/E ratio stands at about 16, somewhat higher than the historical average, suggesting that any significant growth in the ratio is likely to be short-lived.

So, let’s take what we know and plug it into Bogle’s formula. Earnings are currently growing at approximately 2.5% annualized. Let’s (optimistically) assume – despite our nation’s trillion-dollar deficits and the reckless policies being forced upon our nation by the federal government – that the economy finds a way to get closer to its historical average and grow by 4% per year. Let’s further assume that dividend yields remain at their current 2% level (since there don’t seem to be any incentives for corporations to increase their dividends, and the only other way to get an increased yield would be to have a decrease in stock prices). So, ignoring the P/E Ratio for a moment, we’re optimistically projecting stock market returns of 6% per year (4% earnings growth plus 2% dividends) – well below Bogle’s historical average of 9.6%.

Now let’s throw the P/E ratio into the mix.

If the P/E ratio expands, future market returns could be higher than our estimate. If it contracts, future market returns could be lower than our estimate. Unfortunately, there does not appear to be much room for sustainable P/E expansion. As I noted earlier, the P/E ratio for the S&P 500 is currently around 16, slightly above its historical average of 15. But the Shiller P/E, which is probably a better measure of Bogle’s “speculative component” because it uses average earnings from the past 10 years, is currently around 23 – well above its historical average of 16.4.

This analysis is consistent with several recent – and more scientific – studies that have attempted to estimate likely future long-term market returns.  For example, in a recent research paper entitled “The Expected Real Return to Equity”, Missaka Warusawitharana (no, I can’t say it either), an economist on the Federal Reserve’s Board of Governors, concludes that current data indicates future average returns are likely to be 1.5% – 3% lower than historical averages.  These results are consistent with several other peer-reviewed research studies.

All of this information suggests that any significant market rallies are likely to be short-lived. It also suggests that currently there is significantly more downside risk in the market than there is upside risk.  Of course, our crystal ball is no better than anyone else’s: Whether the markets return an average of 6% or 9.6% or 12% per year for the next decade is anybody’s guess.  But the smart money, it would seem, isn’t betting on “Dow 20,000″ anytime soon.  $$