We are talking about the stock market here. Keep firmly in mind the quote: “It’s tough to make predictions especially about the future”. This is as apt today as it was when first uttered by Yogi Berra. But we will still venture undaunted into the forecasting abyss.
Historically common stocks have returned between 10% and 12% over long periods of time, bonds have done about 5%, short term investments like money market funds, 3% and inflation somewhere between 2% and 3%.
The Wall Street Journal recently featured an article (July 5) discussing three forecasting approaches to future investment returns. The first looks at price-to-earnings ratios (PE). Robert Shiller, the Nobel Laureate and Yale University professor, likes to use earnings averaged over a ten year period to look at PE. Over the past nearly 140 years the Shiller PE has averaged 17. Today it is above 25. Cliff Asness, a money manager, has taken the Shiller PEs and computed what the future ten year performance is based on different starting PE levels.
What Asness finds (see chart below) is when price-to-earnings ratios are low, subsequent returns are high and vice versa; when PEs are high subsequent returns are low. With the Shiller PE at 25, the implication is returns are going to be very low going forward. Some critics, however, say that the Shiller PE is unusually high today because earnings the past ten years still include the very poor corporate results in 2008 and 2009. Take these out and the PE looks much better.
A second approach is that of Jack Bogle the father of Vanguard Index Funds. He uses a three step process, adding together the market’s dividend yield (roughly 2%), the long term expected growth in corporate profits (approximately 5%) and the expected change in the future PE. Today he sees earnings and profits implying a 7% stock market return, but with PEs at higher than average levels he reduces the expected return to 4%.
Finally there is the interest rate approach. When rates are high, all other things equal, stock returns should be lower as investors move funds to bonds. And conversely when yields are low, stock prices should be higher. Interest rates today are at extremely low levels so stocks should have an above average going forward return.
So where does all this leave us? We tend to agree with the Bogle method that dividends and expected corporate profit growth implies a 7% return. We nick this return for the slightly above average PE (we don’t think they are as high as Shiller does) and come up with an expected stock market return of 5% to 7%. This is less than what long term investors have come to expect so you might need to boost future savings and temper Retirement portfolio expectations.