The simple math of stock returns
We have noted in many articles of the past that asset prices come from fundamentals (e.g. earnings/dividends) x investor emotion. Below is a reprint of an article from Ben Carlson’s “A Wealth of Common Sense” blog discussing the same notion but from a much higher power than ourselves – namely Vanguard founder John Bogle!
Take it away Mr. Carlson and Mr. Bogle:
Vanguard’s John Bogle has a simple formula for estimating future stock market returns:
I have a reasonable expectations kind of formula that I’ve been using for 25 years and it’s worked the whole 25 years almost perfectly. There’s some decades where it doesn’t work as well as it should but for the full period the reasonable expectations have been almost exactly the same as the returns actually delivered by the S&P 500. And it’s a simple system. And that is you’ve got a dividend yield that’s 2%. Going back a long time it was four and a half or five percent, so there’s a loss right there, suggesting lower returns in the future. Earnings growth has been about 5%. I think it’s going to be very tough to do that in the future, maybe we can do 4%. And stocks are highly priced. The first two are what I call investment aspects of the investment return and the second one is the speculative return – that is what will people pay for a dollar’s worth of earnings.
Bogle’s formula is this:
Future Market Returns = Dividend Yield + Earnings Growth +/- Change in P/E Ratio
He says this formula currently gives him an estimate of stock market returns in the 4-6% range, well below the long-term average that falls in the 8-10% range. You could quibble with some of the details here but I like the fact that this is such a simple model.
Bogle has actually outlined this one before on many occasions. In his book Don’t Count On It he even provided a long-term look at how this formula has played out by decade going all the way back to 1900. Here’s the data (with an update by Mr. Carlson through the end of 2015):
Dividend yields are much lower now than they were in the past (something that can be partially explained away by the increase in share buybacks) while earnings growth and the P/E multiple expansion or contraction have been somewhat more volatile.
What’s interesting here is how inconsistent the change in P/E has been decade-to-decade. At times high earnings growth has led to multiple expansion while other times it led to a contraction in the multiple people were willing to pay for earnings. Fundamentals matter over the very long-term but even over decade-long stretches investor sentiment can trump all. And the reason for this is because the P/E change is really a gauge of investor sentiment or emotions.
When investors are feeling good they are willing to pay a higher multiple of earnings for stocks. When they are feeling nervous they are willing to pay a lower multiple of earnings for stocks. The problem with trying to forecast stock returns is that you’re really trying to guess how people will feel in the future.
You could come up with a reasonable approximation of the impact of dividends and earnings growth over the coming decade and still be way off depending investor allocation preferences or where we’re at in the emotional phase of the cycle.
And Bogle said as much in his interview. He admitted, “I can’t forecast the future, let’s be honest about that. But I can make judgments using reasonable expectations about the future and it seems to me the handwriting is on the wall for lower returns than we’ve had historically.”
And that’s all you can really hope for as an investor when dealing with an uncertain future.
So what if Bogle’s formula is right over the coming years or even decades?
A few thoughts:
- Adjust your expectations.
- Have a contingency plan in place if your expectations aren’t met (save more, work longer, spend less, start a side business, take on a new career, etc.).
- Plan for lower returns either way. If you plan for lower returns and it happens you’ll be ready for it. If you plan for lower returns and it doesn’t happen you’ll be even better off. But if you don’t plan for lower returns and it does happen you’re probably out of luck.
- If you’ve missed out on the huge bull market in U.S. stocks since 2009, don’t expect to jump in now and see similar performance.
- Diversify more broadly beyond U.S. equities in areas that have higher expected returns.
- Behavior and fees will matter more than ever in a lower return environment.
Original Source: Vanguard’s Jack Bogle on Index Funds, Negative Rates
Further Reading: Does a Change in Expectations Require a Change in Strategy?
* Returns used here are nominal and don’t factor inflation into the mix, another potential reason for the changes in P/E multiples over time.
Given the simple math of stock market returns, why use TimingCube, FPResearch, et al.
While we greatly respect Mr. Bogle and the transformational role he has played in the world of investing, particularly for “retail” aka individual investors, we take a different approach at TimingCube and FPResearch. We believe that some level of active management CAN improve returns if only by sidestepping the most damaging of stock market declines. Our models and resulting model portfolios focus on minimizing risk in pursuit of above-market returns. If we only are successful in avoiding the bulk of the next market crisis, then we can handle the lackluster returns that Mr. Bogle calculates above. By avoiding half or more of the next market crash, we will add another 2, 3, 5%+ to our long-term annual returns. To wit, our FPResearch Multi-Asset Model portfolio sports a return of 15% over nearly 20 years of history. Did the strategy outperform the broad stock market every year? No, it did not. In fact, it substantially under-performed the market in some years. BUT (and here’s where our philosophy earns its keep) the FP Multi-Asset strategy never suffered from a market crash. If every market crash delivers a 20-30% loss to the portfolio of a buy-and-hold “passive” investor such as Mr. Bogle, and we are not enduring such losses, we are keeping a whole lot more of our money available to pursue the post-crash bull market. That’s an immediate and substantial positive to our returns – the gain of NOT losing.
Despite a very benign stock market environment over most of the past seven years, we know that another financial crisis is coming and we know our strategies will be prepared and ready once again to protect our capital. The same cannot be said for Mr. Bogle’s buy-and-hold crowd. All that to say that we believe our Models can and will deliver better returns over the long run than the very modest returns that Mr. Bogle projects from corporate earnings, dividends, and the occasional pop in investor enthusiasm.
Market Update
Investors opened the week looking to rebound from the prior Friday’s -2% tumble on interest rate hike fears. Monday did not disappoint with stock participants buying from the market open to take back the bulk of the Friday slide in a +1.5% session move. However, the market took all of that gain back in Tuesday’s trade with interest rate fears resurfacing and oil prices tumbling. Of note, shares of Apple bucked the broad market’s weakness to post a gain on an otherwise ugly day for stocks. Oil again slid on Wednesday pressuring the broad market. However, a breakout in Apple helped tech stocks continue to show well keeping the market indexes near the flat line.
That set the stage for a rally Thursday with Apple following through on its rally and biotech continuing to hold up well in a generally weak market. That pushed the Nasdaq up +1.5% on the day. As strong as tech stocks were on the week, energy stocks slumped badly with oil prices under pressure all week. Friday failed to deliver the new highs that Nasdaq watchers hoped for, though that index continued to outperform in Friday’s -0.4% dip.
Warm wishes and until next week.