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THE DEVELOPMENT OF STOCK AND BOND
RETURNS (APRIL 2000–MARCH 2009)
HANDICAPPING FUTURE
RETURNS
So what’s ahead? How can you judge returns from financial
assets for the years ahead? Although I remain convinced that
no one can predict short-term movements in securities
markets, I do believe that it is possible to estimate the likely
range of long-run rates of return that investors can expect
from financial assets. And it would be unrealistic to anticipate
that the generous double-digit returns earned by stock and
bond investors during the 1980s and 1990s can be expected
during the coming decades of the twenty-first century.
What, then, are the reasonable long-run expectations for
returns? The same methods that I used in the past can be
used today. I will illustrate the long-run return projections as
of late 2010. The reader can perform similar calculations by
using data appropriate for the time the projection is made.
Looking first at the bond market, as of late 2010, we can
get a very good idea of the returns that will be gained by long-
term holders. Holders of good-quality corporate bonds will
earn approximately 5 to 6 percent if the bonds are held to
maturity. Holders of long-term zero-coupon Treasury bonds
until maturity will earn about 4 percent. Those who buy and
hold long-term TIPS (the Treasury’s inflation-protection
securities) will earn a real (after-inflation) return of 2 percent.
Assuming that the inflation rate hovers around 2 percent per
year, both government and corporate bonds will provide
investors with a positive rate of return. Thus, bonds should
be a serviceable investment for the start of the new century.
But remember these returns are considerably lower than they
have been since the late 1960s. Moreover, if inflation
accelerates and interest rates rise, bond prices will fall and
bond returns will be even lower.
What returns can we project for common stocks as of late
2010? We can make reasonable estimates of at least the first
two determinants of equity returns. We know that the 2010
dividend yield for the S&P 500 Index was about 2½ percent.
It is reasonable to assume that earnings can grow at about 5 to
5½ percent over the long term, a rate consistent with
historical rates during periods of restrained inflation and
similar to estimates made by Wall Street securities firms in
late 2010. Adding the initial yield and growth rate together,
we get a projected total return for the S&P 500 of 7½ to 8
percent per year—higher than bond yields but somewhat
below the long-term average since 1926, which had been
about 9.8 percent. This projected rate of return is
substantially below the 18 percent rate of return that was
earned by stockholders during the Age of Exuberance at the
end of the last century.
Of course, the major determinants of stock returns over
short periods of time will be changes in the ways equities are
valued in the market, that is, changes in market price-earnings
multiples. Here I must refer back to my conclusions in
chapter 11, where I suggested that none of the statistical
methods of predicting valuation changes is dependable. I
suspect that even God Almighty does not know what the
“proper” P/E multiple is for the market, nor can future
changes in the multiple be forecast. Changes in valuations are
fundamentally unpredictable. Thus, all we can do is estimate
what returns the market is likely to give us if valuation
relationships do not change. And that figure is probably quite
close to the 7½ to 8 percent estimate I arrived at above.
Investors should ask themselves, however, whether the
valuation levels in the market during late 2010 will in fact
hold up. Price-earnings multiples in late 2010 were in the
midteens, just slightly higher than their long-run historical
average. But dividend yields at 2½ percent were well below
their 4½ percent historical average.
To be sure, interest rates and inflation were both relatively
low during 2010. When interest rates (and inflation) are low,
somewhat higher price-earnings multiples and lower dividend
yields are justified. Still, we can’t simply assume that rates
will always be so low and that inflation will always be
benign.
It is well to remember that our smartest economists were
claiming in the mid-1960s that inflation (then at 1 percent)
was dead and that even minor fluctuations in economic
activity could easily be offset. Remember also that in the
early 1990s, the financial press was replete with stories
touting the wonders of the Japanese economic system and
management techniques and insisting that the extraordinary
multiples in the Japanese stock market were justified. And
the horrific events of September 11, 2001, remind us that we
live in a perilously unstable world, suggesting that investors
should quite rationally expect to receive meaningful risk
premiums if they are to accept the risks of equity ownership.
The unexpected frequently happens.
The point is, don’t invest with a rearview mirror. Don’t
simply project the returns from the past into the new
millennium. The most likely estimates we can make for the
stock market when dividend yields are in the vicinity of 2½
percent is that the total rate of return over the longer run will
be in the upper single digits.
Does my expectation for high single-digit long-run rates of
return imply a prediction of what the market will do during
any specific period of time? Not at all! Remember that we
have lived through fairly long periods (such as the first decade
of the 2000s) when common stocks provided negative
returns. If your expected investment period is only for a
decade or less, no one can predict the returns you will receive
with any degree of accuracy.
As a random walker on Wall Street, I am skeptical that
anyone can predict the course of short-term stock-price
movements, and perhaps we are better off for it. I am
reminded of one of my favorite episodes from the marvelous
old radio serial
I Love a Mystery
. This mystery was about a
greedy stock-market investor who wished that just once he
would be allowed to see the paper, with its stock-price
changes, twenty-four hours in advance. By some occult twist
his wish was granted, and early in the evening he received the
late edition of the next day’s paper. He worked feverishly
through the night planning early-morning purchases and late-
afternoon sales that would guarantee him a killing in the
market. Then, before his elation had diminished, he read
through the remainder of the paper—and came upon his own
obituary. His servant found him dead the next morning.
Because I, fortunately, do not have access to future
newspapers, I cannot tell how stock and bond prices will
behave in any particular period ahead. Nevertheless, I am
convinced that the moderate long-run estimates of bond and
stock returns presented here are the most reasonable ones
that can be made for investment planning decades into the
twenty-first century.
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