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14 Tishrei 5765 - September 29, 2004 | Mordecai Plaut, director Published Weekly
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Observations: US Stock Market Returns are Expected to be Lower
by Mordecai Plaut

Many investors know that US stocks return an average of about 10 percent a year over the long run, and they use that information to guide their investment decisions. However, if they dig a little deeper, they might allocate their money somewhat differently.

The first important point to make is what all the financial proposals are required to say: "Past performance is no guarantee of future results." That is true, but most rational people believe, correctly, that past performance is an indication of future results. We have a rational expectation that the long-term trends of the past will continue. However, in the case of returns from stock investments, it is very important to realize what exactly this past performace was.

Most modern investors believe that the main return from stocks is price appreciation. That is, they expect stock prices to rise 10 percent a year, thinking that they have risen at this rate for more than a century. However this is not what happened. In fact, a good part of the return in the past was from dividends and not price rises.

The best-known advocate for investing in stocks is professor Jeremy Siegel of the Wharton School of Finance. In a recent edition of his very successful book, Stocks for the Long Run, he reports that the total return for U.S. stocks between 1926 and 2001 was an average return of 10.2 percent per year. This information has become widely known, and many investors base their investment approach on the assumption that -- if they are in for the long term so that the averages are likely to assert themselves -- they can expect eventually to realize about 10 percent per year from their stock investments.

However, in a speech at the national conference of the National Association of Personal Financial Advisors (NAPFA) in Toronto in April 2004, Professor Siegel said that right now, because the prices (valuations) of stocks are high relative to historical norms, investors should expect inflation-adjusted real returns of just 5-6 percent per year.

The first thing to understand about historical stock returns is that the 10 percent figure quoted as the "norm" includes inflation. According to Siegel, between 1926 and 2001 the average annual price rise was 3.1 percent. That means that the real return from stocks between 1926 and 2001 was not 10.2 percent, but 6.9 percent (because of the effects of compounding). This means that when Siegel said in April 2004 that stocks should produce real returns of 5-6 percent a year, that is compared to the almost 7 percent historical real returns, not compared to the 10 percent overall return.

It is also important to realize that a very important component of stock returns, historically, was their dividend yield. From 1926 to 2001, dividends brought in 4.1 percent of the total returns. Currently (August 2004), the dividend yield of the S&P 500 Index is only 1.9 percent. It is not clear exactly how much this should impact the expected returns from the stock market, but it is clear that it should lower the expected return. You could say that stock owners in 1926 had a 2.2 percent head start on today. In August 1982, when many observers date the beginning of the current bull market, the S&P 500 yielded 6.3 percent.

The rest of stock returns is price rises. According to Siegel, this created 2.7 percent of the total return figure over the 75 years.

However the experience of most investors, which took place in the last 25 years or so, is far from typical and it has probably given them exaggerated expectations. From July 1982 through February 2000, the top of the recent market bubble, the S&P returned an annual average of 19 percent. From December 1994 through February 2000, the S&P 500 produced an annual average return of 25.8 percent. The NASDAQ produced an even higher return: an average of 43.1 percent! Almost all of this was a rise in prices. Less than 1 percent of that gain came from dividends, showing how atypical the recent period was. This experience still is part of the overall results, and therefore indicates that for the rest of the time, dividends played an even more important role.

Everyone agrees that the core of the value of a company that one buys on the stock market is the profits that it makes. These are usually called "earnings." The stock price can rise if companies earn more. The stock price can also rise if people decide to pay more for the same amount of earnings. People can get excited about a company in the short run, but in the long run, the earnings of the company will determine the price.

According to Siegel, real per-share earnings growth between 1871 and 2001 was only 1.25 percent. Furthermore, most of the growth during the whole 20th century occurred in the 20 years or so following World War II. Excluding that golden period, shareholders spent many decades simply treading water. Almost all of the growth in real dividends occurred during the same period.

How much people are willing to pay for a given amount of earnings is called the "Price-Earnings Ratio" or the stock multiple. It means the number of times the earnings must be multiplied to give the stock price.

In another famous book, Irrational Exuberance, Robert Schiller calculated the average stock multiple between 1871 and 2000 and found that it was around 15. That means that if a company earns $1, its stock will sell for $15.

The current multiple is around 18, which means that right now people are willing to pay about 20 percent more for a dollar of earnings than they have in most of the past. Thus, it is unlikely to rise in the near future, and may well fall.

The Future of the Stock Market

What can we expect from the stock market in the years ahead?

The overall dividend yield is low at 1.9 percent. The stock multiple is high at about 18. If we compare this to the historical conditions that produced the average yield of 10 percent, we can expect lower returns from the stock market in the near future.

If the price/earnings multiple contracts, stock market returns can be negative as well. The multiple is now above the long-term average, but it can be, and has been, below the long-term average as well. In other periods when the market valued earnings so highly, it gave very low returns for the next 10-20 years.

In sum, a rational investor learning from the experience of the last century should expect somewhere around 5-6 percent returns at best over the next long run. An analyst for Morningstar Inc. (Curt Morrison) recently calculated that an optimistic figure for returns is 4.2 percent. That is holding other things equal and just assuming historical earnings growth rates. He also noted that it could just as easily be a quarter of that.

However, this does not seem to be the expectations of most investors. They are still very optimistic. According to a report in the New York Times (8/24/04) an astonishing 18 percent of investors polled by UBS in August said they expected to generate profits of 10 percent to 14 percent in their portfolios over the next 12 months, while 28 percent said they expected to generate gains of 5 percent to 9 percent.

This optimism is itself a bad sign. It is well-known that optimism is always highest just before the market reaches a high.

This article is not a recommendation for or against stocks. It is just intended to help people assign them their proper value and to decide where to put their money based on that.

 

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