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.
