Fundamental Trading Diary

Fundamental analysis of the capital markets

Perpetual 10% Annual Stock Returns

This article is about the assumption of 10% yearly stock returns, where it came from, where it is now, and some opinions on why it may not continue.

It is an amazing thing:  both GDP and inflation have between 1-3% annually, yet the market return since 1909 has averaged just over 9%.  Dow 30 stocks have performed at a clip of 10.53% since 1928.  If you assume that GDP growth is not inflation deflated (which it at least partially is), that is a 4-7% annual out-performance of stocks against economic growth.  The questions asked are  a) why, and b) will it continue.

This does suggest that the private sector and capitalism do work.  Existing business adapts to outperform country-wide economic growth, and returns these gains to the equity holders.

The model used in this forecast factors in historical returns, economic growth, dividend yields and the risk free rate.  The idea is, assuming economic growth continuing on a historical pace, the lower (risk free rate / dividend yield) is, the larger gains the market expects.  This particular assumption is also central to a few other major models, including the Fed Model (and variants).  The best model I’ve seen using these assumptions is from cxoadvisory.

A criticism leveled at this model is that the dividend yield has seemed to permanently shift to under 2% from the historical average of over 4%, and that this indicates that the risk premium has dramatically increased.

The most persistent challenger has been Rob Arnott, a Pasadena money manager and editor of the Financial Analysts Journal, who thinks future equity returns could be below 6%. (See "Dueling Market Forecasts" chart.) The big difference between his forecast and Ibbotson’s is that Arnott uses the current dividend yield (1.76%) as a starting point, while Ibbotson goes with the much higher long-term average yield (4.23%). Ibbotson believes the historical number provides a better picture of what investors think is ahead. He still relies on the assumption that markets are efficient, so current dividend yields must be low for a reason–his guess is that investors are expecting big growth in earnings (and dividends) in the future. Arnott, whose research has shown that low yields in the past were followed by slow earnings growth, thinks that’s balderdash. "One of my biggest beefs with the academic community is the notion that theory is fact," he complains. "When they find evidence that contradicts the theory, instead of saying, ‘Wonderful, let’s improve the theory,’ they throw it out because it conflicts with theory."

One immediate comment is that the dividend yield likely has fundamentally changed, but not because of earnings expectations;  Tax considerations and advances in investment banking have encouraged closed-end funds and companies to perform stock buy-backs instead of disbursing dividends.

What makes the earnings picture for the future look grim is the generational retirement of the baby boomers combined with what looks like another savings & loan crisis.

The question really turns into whether well managed companies need the kind of economic and credit expansion to succeed and grow their earnings.  Stock indexes, and stocks themselves by extension, are subject to economic darwinism.  Investment capital is taken away from companies who are not giving high returns on equity and assets, and these companies are replaced by organisations which do.

As a consequence, I do believe that stocks will continue to out-perform.  I believe that small-cap value stocks will do particularly well (as they historically have) in comparison as vehicle for achieving the most innovative ways of getting value and returns on investment.


September 2, 2008 - Posted by | Uncategorized

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