Investors need a return to reality

DALLAS — Listen to a stockbroker or financial planner hawk their services and you will almost certainly hear words to this effect:

You can expect the stock market to return an average of 10 percent a year over the long term.

That statistic is trotted out with such certitude that most investors accept it as financial gospel. But can investors who start buying stocks today actually expect that kind of return over the next 10, 20 and 30 years?

“From 2005, guess the length of time that is needed to assure the long-term average,” said Ed Easterling, president of Crestmont Research, a Dallas investment research firm. “The answer — probably never.”

Easterling is not alone in his effort to lower investor expectations. An increasing number of academics and financial experts believe market returns over the next few decades won’t match previous decades.

A more realistic return — or, as Easterling puts it, a return that a rational investor can expect — is somewhere between 6 percent and 7 percent. The respected Leuthold Group, a Minneapolis research firm, also estimates long-term market returns in that range.

“It’s unreasonable for investors to expect double-digit returns,” said Eric Bjorgen, senior research analyst at Leuthold. “Too many investors tether their expectations to what happened in the last 20 years, but that’s not likely to happen again in our lifetime.”

A look back at stock market history will show why. The average compounded annual return of the Standard & Poor’s 500 index from 1926 to 2004 is 10.4 percent, according to Ibbotson Associates Inc., a Chicago research firm.

Many people just assume those same returns over the next few decades and project from that how much they will accumulate for their retirement.

But what they are actually doing is betting that another market bubble will push stock valuations to the limit as they did in the late 1990s, Bjorgen said.

“That period was a statistical outlier, an aberration, that comes around maybe every 75 years,” he said. “Rational people shouldn’t base their financial expectations on the madness of crowds.”

Three components contribute to total stock market returns: earnings, dividends and the change in stock valuations.

Historically, corporate earnings have grown 6.1 percent annually, and that figure includes an inflation rate of 3 percent.

Many investors have the skewed notion that the double-digit earnings growth in recent quarters is the norm. It’s not.

As with stock market returns, the long-term future of earnings growth is likely to be below average.

“We got record earnings growth beginning in 2002 after one of the biggest bubble collapses in history in 2000,” said James Stack, editor of InvesTech Research and a market historian. “Just wait until the next recession when earnings growth turns negative again, and people will understand that earnings don’t always grow 15 to 20 percent.”

In any case, to even get to the 6 percent range, a healthy dose of inflation is needed. And that’s anything but certain, because the Federal Reserve has become increasingly adept at controlling inflation.

Easterling predicts a low inflationary environment that will reduce the earnings contribution to long-term stock returns by 1 percentage point. That takes the average annual market return from 10.4 percent to 9.4 percent.

The second component of stock market returns — dividends — has accounted for a sizable portion of returns over the years. In fact, the average dividend yield of the S&P 500 since 1926 is 4.5 percent, according to Ibbotson.

(Dividend yield is the annual cash dividend that companies pay their shareholders divided by the stock price. A company that has a stock price of $10 a share and pays a 45-cents-a-share dividend has a dividend yield of 4.5 percent.)

Investors shouldn’t count on a 4.5 percent dividend yield in the future, though, because stock prices are much higher now relative to earnings than they were in the past. To better understand this, consider the company above with the $10 stock price and 45-cent dividend.

If the stock price climbed to $20 a share, the company would still be paying the 45-cent dividend, but the yield drops to 2.3 percent because the stock price is higher. It’s simple arithmetic.

The stock market today is more expensive than it was 79 years ago. The way this is determined is by looking at the market’s price-to-earnings (P/E) ratio. The P/E ratio is a company’s share price divided by its earnings per share.

For example, a company with a $20 stock price and $2 per share in earnings has a P/E of 10.

In 1926, the price-to-earnings ratio of the S&P 500 was 10. Today it is 19, or about double. In other words, today you pay about twice as much for every dollar of earnings.

“That explains why dividend yields today are about half of what they were 79 years ago,” Easterling said. “So the market’s return from dividend yields will be about half of the historical average as long as valuations stay at this level.”

And that takes the average annual market return from 9.4 percent to 7.2 percent.

The third and final component involves the change in stock prices, or valuation.

As mentioned above, the valuation of the stock market almost doubled from 1926 to 2004, with the P/E of the S&P 500 moving from 10 to 19.

This growth in stock prices contributed almost 1 percentage point of the 10.4 percent return, according to Ibbotson.

The problem for investors looking for that same contribution going forward is that the market P/E has to double from the present level to about 40.

The likelihood of that happening is very slim.

Peng Chen, director of research at Ibbotson, points out that the P/E of the S&P has been over 30 only twice — in 1929 and 1999.

In fact, there are a number of economists who predict that the P/E levels will retreat toward 15, which is the historical average.