Whither Stocks?

PREDICTING SHORT-TERM stock market returns is impossible. Even forecasting long-run returns is tough to do with any precision. Still, it’s important to have some sense for what you might earn over the next 10 years, so you don’t save too little or spend too much.

Where to begin? Don’t simply extrapolate recent returns or rely on long-run historical averages. Instead, consider stock market returns in terms of three components: the dividend yield, earnings growth and the price put on those earnings, in the form of the price-earnings ratio.

If you buy U.S. stocks, you might get a dividend yield of roughly 2%. Meanwhile, you might assume that the economy—and hence corporate profits—will grow at a nominal 4% a year, comprised of perhaps 2% inflation and 2% real economic growth. Combining the 2% dividend yield and 4% nominal growth would give you a 6% return.

But what about the market’s P/E? It’s higher than the long-run historical average based on cyclically adjusted 10-year earnings, so the odds suggest P/Es are more likely to fall over the next 10 years than climb. But that’s not a certainty. A 2012 study by Vanguard Group looked at a variety of financial metrics, and found that both cyclically adjusted P/E ratios and P/Es based on trailing 12-month reported earnings were the best predictors of stock returns over the next 10 years. Even so, they explained just 40% of returns.

In addition to falling P/Es, stock investors face three other risks. First, profit margins may shrink. Second, earnings per share may lag behind economic growth because of share dilution. Third, economic growth may be even more sluggish than the relatively tepid growth of the past decade. All this suggests there’s a risk of disappointment. Result? Over the next 10 years, stocks might have a total return—share-price gain plus dividends—of less than 6% a year, while inflation runs at 2%. This sub–6% return doesn’t reflect the hit from investment costs and taxes. The outlook for foreign stocks appears brighter, thanks to lower valuations, and thus a globally diversified portfolio might return somewhat more than 6% a year, before costs and taxes.

What if the stars align, the bad stuff doesn’t happen and the U.S. market’s P/E climbs from current levels? While that might seem like a happy prospect, don’t be too quick to cheer: You may discover that you’re effectively borrowing from the future.

Next: Borrowing Returns

Previous: Historical Valuations

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