Efficient Frontier
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William J. Bernstein

The Returns Fairy. . . Explained

Around here we have an unfortunate tendency to slip into jargon and shorthand. While helping to establish credibility with the professional-finance secret-handshake set, it does not do much to disseminate our message to the folks we’d really like to reach—the rank and file of small investors, portfolio managers, financial planners, bank trust officers and, yes, even stockbrokers. With this in mind, I’m going to discuss the single most important issue in finance—future stock market returns—in the clearest, most descriptive, least mathematical terms possible.

For starters, let’s be clear what we’re talking about. Nobody knows what the market is going to do tomorrow, next month, or even in the next five years. And in the final analysis, what the market does over such relatively short periods is irrelevant to the average investor. What is important is return over the next few decades, and we do have a pretty good idea of what’s going to happen over such long time periods. We don’t want to tip our hand too early, but we’ll warn you, you’d better be in a good mood before you read this because you won’t be by the time you’re done.

The biggest area of confusion among the investing public concerns just where stock returns come from. The most popular misconception is that future stock returns somehow derive from past stock returns—that is, from the Stock-Returns Fairy. In the past few decades, the packaging of historical financial returns has become an industry bigger than the GDP of some South American nations. The silliness of this approach is obvious: if you pay twice as much for an asset as you should have, that increases the return of the guy who sold it to you, just as surely as it reduces your future return. This is easily understandable to the investor who bought Japanese stocks in 1989 because of their high prior returns. Or, as Warren Buffett put it, if stock returns came from history books, then the richest folks would be librarians.

Happily, the opposite also occurs. A good example of how misleading past returns can be comes from the history of long Treasury bonds before and after 1981. For the 50 years from 1932 to 1981, their return was only 2.95%, almost a full percent less than the inflation rate of 3.80%. Certainly, the historical record of this asset was not encouraging. Yet common sense dictated in 1981 that the bond yield of 15% was more predictive of its future return than the historical data. And, over the next 15 years, the return of the long Treasury was in fact 13.42%—slightly lower than the predicted return because the coupons had to be reinvested at an ever-falling rate.

So just where do stock returns come from? In order to answer this question, first ask yourself this: how much would you be willing to pay for a business that distributes $10,000 each and every year? Let’s say you arrive at a figure of $200,000. You’ve just determined that the return of your investment will be 5% ($10,000 / $200,000). This is the same as saying you’re valuing the income stream of that business at 20 times its annual amount. This is its market multiple and what determines the market value of your business on a day-to-day basis. If one day the market decides that the business, which on that day is still earning $10,000 per year, is now worth only 15 times income, you have lost 25% of your investment value. Thus, in the very long term, stock price increases come from only one source: increases in dividend income. To show this relationship, we’ve plotted the per-share dividends, earnings, and price of the S&P 500 since 1871.

As you can see, the value of the stock market almost exactly tracks the dividends and earnings it produces; in short, it behaves just like any other business.

So far, so good. Now, assume that the earnings of your business are growing at a rate of 5% per year. If the market multiple remains at 20 times the income of the business, then so too will the market value of your business also increase by 5% per year. In other words, since next year your business will be earning $10,500, it will be worth 20 times that, or $210,000. If the market multiple remains the same, then your return will be the sum of the income rate (5%) and the growth rate (5%), or 10% per year.

Thus we see that the return on your investment is simply the sum of three terms:

The first two terms are easy to understand. A company that yields no income but grows at 10% per year and one that yields a 10% dividend but does not grow are equivalent. It is also the same as a company with a 2% dividend and 8% growth, or an 8% dividend and 2% growth, and so on.

Unfortunately, the last term—the change in market multiple—is the source of a great deal of mischief. Take a typical day in the market for a company with a 5% dividend and 5% dividend growth, with an expected return of 10% per year. Assuming 250 trading days in the year, each day you can then expect a return of about 0.04%. However, it fairly common to see stock prices change by 2% on a given day. Thus, on any given day, the change in market price is caused almost entirely by the change in multiple. This is true both at the level of individual stocks and the market as a whole. And over one-year periods, market-multiple swings of 25% in either direction are not at all unusual, swamping the 10% expected return.

Only in the very long run do the first two terms—the hypothetical 10% return discussed above—dominate. At an expected return of 10% compounded over thirty years, $1.00 grows to $17.45. If the market multiple halved during those thirty years, the compounded return would fall only to 7.5%, and if the market multiple doubled, the return would increase only to 12.6%, both of which are still tolerably close to the expected return of 10%. Put another way, a halving or doubling of multiple over thirty years changes the long-term annualized return by about 2.5% in either direction. A generation (say, twenty years) is finally long enough for the first two terms—the sum of earnings and dividends—to overwhelm the change in multiple. Jack Bogle of the Vanguard Group calls the former the "fundamental return" of stocks, while the last term is the "speculative return." Only over long periods of time does the former dominate the latter in importance.

Now that we’ve laid the groundwork, let’s see where our model takes us. From 1926 to 2002, stock dividends averaged 4.3% and dividend growth averaged 4.5%. Thus, the "fundamental return" of stocks for the period was 8.8%. But during that same period the dividend yield of the market decreased from about 5% to 1.5%. Over the 77-year period, this compounds out to a 1.6% per-year increase in the "dividend multiple" of the market. Add the 8.8% fundamental return to this 1.6% speculative return and you get 10.4%. The actual return of the market? 10.2%. Not too shabby.

Finally, we are able to estimate stock returns. Recall, the dividend yield of the market is currently only 1.5%. And, as we’ve already seen, the annualized growth of dividends is about 4.5%, for a nominal expected stock return of 6%. Ah, you say, dividends don’t matter any more; share prices will soar as companies grow their revenues and earnings to the sky using dramatic technology-driven productivity increases. There’s only one problem: it ain’t happening. Take a close look at the right edge of the above graph. Do you see any acceleration in earnings growth? If you do, then clip the title of this article for 10% off your next optometry visit. (The sharp-eyed among you may detect that the slope of all three plots is slightly higher during the second half of the period. Alas, it is entirely due to inflation; in real terms, the growth rate of corporate dividends and earnings did not increase during the twentieth century.)

There’s an even more serious problem with the rapid-growth theory—it’s incompatible with fundamental macroeconomics. Over the past century, the per-capita growth of GDP in the U.S., the world’s most successful economy, has been about 2% after inflation and shows no sign of acceleration in the past quarter century. It is impossible for long-term corporate growth to be higher than GDP growth for this would entail corporate profits eventually growing larger than the economy itself. And even before this came close to happening, an ever-increasing portion of national income that flowed away from individuals and towards corporations would prove politically untenable. Goodbye Adam Smith and Jude Wanniski. Hello Karl Marx and Warren Beatty.

The other way out of the low future-expected-return trap is for multiples to increase even further: Add 4% of multiple expansion every year to the above 6% fundamental return and you’re back to double digits. This might work for a brief period (which is why the prediction of short-term market movements is a task reserved for fools, small children, and institutional strategists). But at a 4% expansion rate, dividend and earnings ratios double every 18 years; our grandkids would find themselves in a world of quadruple-digit multiples.

Three years ago, this dour message fell on mostly deaf ears. Six percent nominal returns? Heck, you could make that in thirty seconds of day trading. Now, with bond yields in Truman-Eisenhower territory, a six-percent annual return from stocks doesn’t look that bad. And, as always, it will come prepackaged with a lifetime supply of stomach acid.

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