In yesterday’s post we discussed the idea of valuing the stock market like a bond, which is inspired by the academic research and the historical record. Today, we apply the concept to the real world by plugging in some numbers in an effort to develop a bit of perspective on estimating the long-run return for the stock market. It’s an imperfect art, to be sure, and one that ultimately requires far more detail than we can provide here. But every journey starts with a first step.
Let’s begin by considering the current dividend yield for U.S. stocks, defined by the S&P 500. The market’s yield last month was 1.9%, the lowest since December 2007, the start of the recession. As we noted yesterday, there’s a long line of research showing that current yield is linked with the future long-run return for the stock market. The rule of thumb is that higher yields imply higher expected return, and vice versa. Accordingly, expectations about future returns for equities should be lower today than, say, March 2009, when the market’s yield was quite a bit higher at 3.6%.
Burton Malkiel calls the clues thrown off by dividend yield a “dividend jackpot,” overstating the case for effect only slightly. As he explains in A Random Walk Down Wall Street, “investors have earned higher total rates of return from the stock market when the initial dividend yield of the market portfolio was relatively high, and relatively low future rates of return when stocks were purchased at low dividend yields.”
But how much is “high,” and how little is “low.” To put a number on these vagaries, we need to run additional analysis. The possibilities, of course, are endless and we’ll only scratch the surface (just barely) here. A simple way to begin is with the dividend growth model. In its basic form, assuming a constant rate of change for dividends, this model advises that the expected return on stocks is calculated as the current dividend yield plus the long-term rate of growth on dividends. Some finance textbooks, such as The Cost of Capital: Intermediate Theory, explain this as “inferring” the expected return for stocks from dividends.
Adding last month’s 1.9% yield to the 5.1% historical rate of growth in dividends for the past 60 years produces an expected return of 7.0% (1.9% + 5.1%). That’s hardly the last word on developing estimates for the stock market’s expected return, but it’s a good place to start. But it’s only a beginning. We might, for instance, attempt to estimate the outlook for dividend growth for, say, the next 10 years rather than simply extrapolating the historical trend.
Once again, there are many models to consider. One simple approach is assuming that the growth in dividends will match economic growth. That means we need an estimate for economic growth. For the past 60 years through the end of 2009, U.S. GDP has risen at an annualized 6.8% rate in nominal terms. That’s almost certainly too high for, say, the decade ahead. Suffice to say, the outlook for the U.S. economy in 2010, for any number of reasons, is quite a bit more modest than it was in, say, 1950.
As one possibility for developing a more realistic basis for projecting economic growth, let’s take the Congressional Budget Office’s current forecast for U.S. GDP through 2020. That works out to an annualized nominal rise of roughly 4.3%. Adding the current stock market dividend yield of 1.9% to that economic outlook gives us expected return for equities of 6.2%. By comparison, the long-term historical return on U.S. stocks since 1926 is substantially higher at 9.8%, according to the 2010 Ibbotson SBBI Classic Yearbook.
Ultimately, there are no easy answers in forecasting expected returns, for stocks or any other asset class. The future’s uncertain—always. But investing requires making assumptions, including assumptions about future returns. History is a guide, but we need more. Indeed, one of the key lesson in financial economics, along with real-world experience, is that investment results are highly dependent on when you invest. That means that we should think carefully about the current economic and financial climate, including asset valuations, and how that compares with our forecasts of the future.
It’s tempting to think that there are short cuts. But if we’re going to develop compelling intuition about prospective return, we must forecast continually and intelligently, by drawing on a variety of resources. Dividend-based forecasting is just one example, but no one should assume it’s the only one.
Yes, it’s all adds up to a lot of work, but that’s not surprising. If it was easy, the crowd would load up on risky assets and reap the rewards, and in the process bid up prices to the point that expected risk premiums are zero, if not negative. The reality, of course, is quite different. There’s an eternal debate about expected return. What’s more, expected returns are constantly changing. That implies that investors need to be constantly vigilant in developing expectations.
In short, making informed estimates about returns is a process rather than a one-time guess.