Waiting for Average Returns

Average returns

Today’s post is about a report from Crestmont Research, which warns investors not to expect historical average returns in the future.

Waiting For Average Returns

Ed Easterling

Waiting for Average is a recently updated report from Ed Easterling at Crestmont Research, who we met last year when we looked at their “Half and Half” investment strategy.

Ed’s gloomy prognosis is that the long-term average returns from the stock market will never be seen again, no matter how long today’s investors wait.

  • Of course, the key to that statement is “today’s investors”.
  • There may be investors in the future who manage to achieve the historical average return.
  • Whether they do will depend on what happens between now and the time that they invest.
Lower than Average Returns

The long-term average return from the US stock market is 10.1%.

Ed is basing his analysis on the Ibbotson Classic Yearbook (published in the US by Morningstar).

  • This has 89 years of data, starting in 1926.

Ed claims that the returns from the next 89 years will be less than 10.1%, and indeed not much more than half of that.

Components of return

Ed identifies three components to stock market returns, which I think we can all agree on:

  1. change in company earnings (earnings growth)
  2. changes in market valuation (PE ratio)
  3. dividends (as measured by the market dividend yield)

Ibbotson has calculated the contribution of each of these three to the 89-year returns:

  • earnings growth contributed 5.2% pa
  • an increase in PE contributed 0.6% pa
    • note that over 89 years this means a more than doubling of the 1926 PE of 10.2
  • dividend yield averaged 4.3%
    • this high figure is largely due to the low starting PE
Future expectations

Let’s start with PE, which is close to historical highs (excluding the bubbles before crashes).

  • Bull markets generally peak with PE in the low to mid-20s.

In fact, Ed argues in his book Unexpected Returns (pp 155-161, for those planning to buy the text) that the market PE can’t be sustained above the mid-20s.

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So assuming that PE ratios stay at their current high levels, we can deduct the 0.6% contribution to annual returns.

  • We are now down to 9.5% for future returns.

Earnings growth is driven by economic growth.

  • A good proxy for earnings growth is nominal GDP, which is real GDP plus inflation.

So here we have a double whammy – real growth is expected to be slower, and inflation is expected to be lower.

  • Ed estimates that growth will be at least 1.5% lower in the future, leading to corporate earnings growing at 1.5% pa less than in the past.
  • Ed also points out that if inflation picks up, the higher nominal growth will be offset (and more) by a PE contraction.

So we are now down to a best case scenario of 8.0% for future stock returns.

The third component of returns – dividend yield – is mathematically related to the starting PE (see pp 103-105 if you bought the book).

  • In 1926, with a PE of around 10, the dividend yield was more than 4%.
  • Today with the PE over 25, the normalized dividend yield is close to 2%.
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On average, corporate dividend policies (payout rates) do not change with PE.

  • Most US companies pay out just less than half of their earnings per share.

So the change in starting PE knocks another 2% pa off our expected returns.

  • We now have a best-case forecast of 6.0% for future returns.
PE declines

The picture could, of course, become worse, should PE ratings decline.

  • But the silver lining is that following a PE decline, the prospects for future returns from that point would improve.

To get back to the historical return of 10.2% pa, PE values for US stocks would have to fall from 25 right down to 10.2 – a near 60% decline in stock prices.

  • I don’t expect that to happen, but if it did, it would be time to fill your boots with stocks once more.

In the meantime, be aware that at the moment, past returns really aren’t a guide to the future.

Until next time.

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 39 years, with some success.

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2 Responses

  1. Hi Mike, totally agree with all of that. The UK picture is slightly different than the US, but the basic building blocks of long-term returns are the same.

    The only problem I have with these long-term return calculations is that in the long-term we’re all dead anyway, so nobody really invests over the long-term (except, perhaps, for endowment funds).

    Realistically most people have a 10-50 year time horizon, and over that sort of period the dominant factor is usually changes to the PE ratio, or more usefully, the CAPE ratio.

    Add in the massive uncertainty future PE ratios and the need, for most people, of broad multi asset class diversification, and forecasts of long-term equity returns become largely unimportant.

    Having said that, I’ve just written a 1-yr forecast for the FTSE 250, so I guess I shouldn’t try to undermine the idea of forecasts too much.

    • Mike Rawson says:

      I think we all have to decide for ourselves what is short term and what is long term.

      I’ve been investing for 30 years and I hope I’ve got another 30 years to go. So that’s long-term for me.

      You can’t be too precise about these forecasts, but I expect returns in the next 30 years to be lower than in the past 30 years. That’s the key point – the past is not a guide to the future.

      I have a problem with the CAPE (especially in the US) because it only ever predicts that markets will go down – possibly because it doesn’t take account (no pun intended) of changes to accounting standards.

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Waiting for Average Returns

by Mike Rawson time to read: 2 min