November Update, 2019: A Thought Experiment On Expected Future Stock Returns

There are forecasts of all types telling us what will happen to stocks over a one-year period and frankly, most of it is bunk. It’s bunk because there are too many variables and too many unknowns to forecast with any real accuracy consistently. That’s not to say that forecasts aren’t useful. The trick is to use as many data points as possible and that often means looking at long-term historical data. The future will not look exactly like the past, but it’s always been a good guide to show us how things tend to evolve.

One tool with very good long-term forecasting predictability of future returns has been to look at the long-term earnings growth of a large set of companies, say the S&P 500 Index, and compare that to the value of those companies. For example, if all the companies earn a combined $155 and they are valued at $3,000, that brings their Price/Earnings (P/E) multiple to approximately 19X their earnings. That’s about where stocks are trading today and that’s high from a historical perspective (the average since 1900 is 16X). Conversely, if all those earnings were paid in dividends you would earn about 5%. Unfortunately, not all earnings are paid out. Only about $57 (or 37%) are given to you as dividends and the rest are kept by the companies. The dividend yield is ~2% right now and the historical average since 1871 is ~4.4%.

Given where we are compared to long-term averages, we are about 20% over-valued on earnings valuations and about 100% over-valued on dividends. Yikes!! That doesn’t sound good, so let’s find some reasons why this time is different so that we don’t lose our collective minds worrying about a crash.

Some will say that since interest rates are so low stocks must be highly valued because “there is no alternative” (TINA). Sure, that may be true, but first, rates are low because things are barely growing (including corporate earnings). Second, rates have been low before (below the average and less than 3%) for very long periods of time and still dividends were rarely below 3% (until 1961 and then only briefly). In fact, dividends never sustainably started being below 3% until 1992 and interest rates were above 5%. So, I don’t see the TINA argument being backed up by facts. You see, interest rates were consistently higher than dividends from 1992 until the height of the financial crisis in 2008. As we all know, stocks then fell a lot. This should have raised dividend yields but yields didn’t rise as fast as stocks fell because companies (especially those safe bank stocks) cut their dividends when earnings vanished, and economic growth collapsed.

To recap; most of the time since 1871 dividends have been higher than interest rates, and when they were lower you could have invested in safe interest-bearing investments at much higher returns. But many investors today seem to prefer low-yielding stocks, banking on capital appreciation to obtain their objectives. That’s fine and a reasonable thing to do, but here’s the thing; stock prices are ultimately driven by two things, dividends and earnings growth. As we see above, dividend yields are historically low and investors are paying higher than average valuations for profits. Profits have averaged 4% growth since 1871 and last year they were down about 2%. Profits are likely to grow somewhat slowly next year too because of sluggish global growth. That leads us to the conclusion that stock market returns should be lower than average.

How and when will this happen? We don’t have a clue when, that’s market timing, but here’s how returns could improve:

Dividends could grow, but that is tough when earnings are growing slowly (if at all) as they are now. Profits could rise, but that’s tough because global growth is slow (that’s why interest rates are so low). Valuations are already high so growth from P/E expansion is unlikely as we are already at premiums. Stocks could fall (lower P/E multiples), reflecting more pessimistic outlooks which would reset the bar on dividend yields and valuations. Given that stocks have basically treaded water for the past year, Mr. Market is telling us it is hopeful profits will rebound, interest rates will not rise too much, dividends will rise, and investors will continue to be optimistic about the future via continued high valuations.

One year ago, investors were very pessimistic about the future and valuations plunged 20% in 90 days. Now they are more optimistic, but the net effect has been basically no change. If anything, this thought experiment shows us that the historical facts tell us to exercise caution and that an investor’s state of mind is unreliable as a valuation guide (and even less reliable when it comes to predicting timing).

Lastly, the common wisdom underpinning all markets is that low interest rates and low inflation are here forever. Looking to the past and all the changes that have occurred over the last 150 years, one thing jumps out; interest rates and inflation are highly volatile. Everyone is betting on calm when the facts are screaming that every government in the world is trying to create inflation. Given that governments are the ones who print the money, we would bet on them winning that war at some point which means a lot of volatility. That’s not being factored into many forecasts right now and that’s not consistent with the historical facts.

One of the biggest risks in investing will always be thinking that this time is different.

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