Eddy Elfenbein: What Should Investors Expect?

by Eddy Elfenbein, Crossing Wall Street

March 11, 2014

In the Wall Street Journal, Brett Arends writes about a subject close to my heart: what can investors expect from the stock market.

The problem is we can only go on past information. Most long-term studies begin the 1920s, and they show that the stock market has returned about 7% per year, once we include dividends and inflation.

The problem with that is it covers what Henry Luce called the “American Century,” when our way of life of democratic capitalism spread all over the world. I don’t think that’s repeatable. I’m still optimistic for America, mind you, but I don’t think we’ll see quite the triumph of free minds and free markets that we saw in the 20th century.

The great bull market from 1942 to 1966 was astonishing. I don’t think many investors realize this. It’s not really discussed because, I suppose, the market never truly crashed again. We have to remember how poorly valued stocks were for many years. The real yield for stocks was often much higher than inflation. Arends writes:

For example, from the 1920s through the early 1990s stock investors collected an average annual return of 4% just from their dividends. Today the figure is less than 2%. Logically we should expect future total returns to be at least two percentage points lower.

I disagree that lower dividend yields will translate to lower returns. Even putting aside buybacks (which I don’t like), the payout ratio is far lower than it used to be. Companies used to shell out a large percentage of their profits as dividends. Nowadays, it’s far less.

Back in the 1950s, U.S. stocks traded at an average of about 11 times the previous year’s earnings, according to analysts. In the 1940s and the early 1980s, valuations fell as low as eight times earnings.

But after 1982 they became sharply revalued upward. Today the S&P 500 trades at about 18 times earnings. To expect the same again is to engage in Bubble Logic—the belief that things will keep going up simply because they have.

Again, my view is slightly different. The valuations of the 1940s and 1950s were, indeed, very low. But I believe the valuation revolution of the 1960s is still in place. The problem is that low inflation brought earnings multiples back down again in the 1970s, and that appeared to be mean reversion. I don’t believe it’s reasonable to assume that we’ll revert to single-digit multiples, unless there’s high inflation.

Strip out these one-off gains and inflation, Rob Arnott recently suggested, and investors ought more realistically to expect about 1.5% a year plus dividends—meaning, in the current environment, an annual return of about 3.5% in real terms. That’s a far cry from 10%.

I think that’s slightly pessimistic. I would say that investors should expect real returns of 5% from common stocks. That’s 2.5% from capital gains and 2.5% from dividends.

Copyright © Eddy Elfenbein, Crossing Wall Street

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