Many investors have come to loathe the stock market. This dissatisfaction is primarily a result of the collapse in stock prices between the tech bubble, in March of 2000, and the bottom of the financial panic, in 2009. For the past three years, the Vanguard 500 Index (VFINX) has risen 23.8% per year. At the end of March, annualized 10-year VFINX returns are +4.02%, and 15-year returns are +5.86% per year. While the long-term returns haven’t met common financial planning forecasts of 10% annually for equity returns, they don’t seem to justify the current antipathy toward stocks, either.
We believe that the “lost decade” in stocks is primarily a result of the bubble valuations of 2000. More than the uncertainties in Europe, more than the 2006 real estate bubble and subsequent financial panic, and even more than the fiscal ineptitude by our politicians in Washington, the current investor dissatisfaction results from irrational exuberance 12 years ago.
Back in 2000, the market sold at roughly 30-times earnings. $1 of earnings, selling for $30, represents a 3.3% return on investment. Helping investors is the fact that corporate earnings tend to adjust for inflation, over time. Corporate earnings have generally doubled since 2000. Hurting stocks, however, has been the subsequent P/E Ratio adjustment, from a nosebleed 30-times earnings to a much more rational 14-times earnings, currently. With corporate earnings at roughly $2, and a 14 multiple, that would put the current value at about $28.
Thus, roughly, since 2000 companies lost $5 in valuation but earned about $15 from operations, for a total return of $10 on a $30 investment (or approximately 3.3% per year).
Investor returns, then, are comprised of one part Return-On-Investment, one part Inflation-Adjustment, and one part P/E Ratio adjustment. Moreover, a simplistic forecast of a 3.3% return to stock investors made in 2000, based simply on the earnings yield of a market selling at a 30X multiple, would have proven to be fairly prescient.
A simplistic forecast for equity returns, based on today’s 14X multiple, would be that stocks can return 7% annually over the next decade.
Based on the three-part variable analysis, and assuming that today’s 14X multiple stays constant, a forecast of 7% inflation-adjusted return seems reasonable. If inflation decreases purchasing power by 3% per year, it suggests a total return to stock investors of 7% + 3%, or a nominal 10% rate of return. In a world where 30-year government bonds yield a nominal return of only 3.33% (i.e. unadjusted for inflation), it is easy to see why money may still flow toward equities, even after the first quarter market rally.
During the past decade, the stock market didn’t return a nice, steady 4 percent per year, of course. It was a gut wrenching ride with two full-on bear markets through which investors suffered. Going forward, I would expect that volatility to continue. But, who knows? More importantly, investors need to note that cash offers virtually no return and bonds offer little return and material price risk. Stocks, by comparison, offer reasonable profit potential in spite of the probability of a rough ride at certain points in the cycle.
There are a number of specific risks that I believe investors should take very seriously. Profit margins are close to all-time highs. There is a risk to corporate profits from shrinking margins. Eventually the Federal Reserve will choose to, or be forced to, allow interest rates to rise to natural market levels. When this happens, savers who have been forced to invest in stocks because of the paltry rates available on bonds will likely pull their money back into fixed income instruments. This would likely, at least temporarily, hurt stocks. In the long run, however, these factors will likely just depress stocks for a short while.
In the long run, I haven’t heard many sound arguments as to why stocks cannot provide long-term returns that exceed the returns available to savers and bond investors. Investors need to be prepared for a rough ride in order to achieve these returns, however.
In the short run, I believe that the market can continue to climb the wall of worry. In fact, today’s fear and pessimism is perhaps the most comforting factor of all.
In the medium-term, I expect more rough sledding ahead. When interest rates rise to the point where money starts flowing out of stocks and back into bonds – i.e. when interest rates rise from confiscatory levels and the Fed abandons its current policy of financial repression – the stock markets may experience a pretty sharp drop. Although we will certainly try to position portfolios appropriately, timing markets is a difficult endeavor.
In the long-run, I agree with Jeremy Grantham and other prognosticators who note that while stock markets may not turn in record-setting long-run rates of return, stock investors will likely fair better than bond investors and savers in the years to come, especially when measuring returns after inflation.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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