Speculating on Speculation

Jonathan Clements  |  July 24, 2015

WANT TO FORECAST the stock market’s 10-year return? You might start by estimating the economy’s growth rate, consider what that would mean for corporate earnings, and then ponder what value investors will put on those earnings. Problem is, with this approach, you begin by making reasonable estimates—and end up engaging in wild speculation.

The first step doesn’t seem so tough: estimating the U.S. economy’s growth rate. If you look back over the past half century, the real (after-inflation) GDP growth rate has been 3% a year. The worst year was a 2.8% contraction in 2009 and the best was a 7.3% spurt in 1984. Still, 36 of the 50 years were above 0% but below 5%. That’s moderately reassuring: It tells you that, most of the time, GDP growth hasn’t been that far from the 3% long-run average. Moreover, 11 of the 14 outliers occurred in the first 20 years—and just three in the 30 years since.

The not-so-good news: GDP growth has been slowing over the past 50 years. Since 2000, it’s averaged just 1.8% a year. Partly, that reflects the Great Recession. But it also reflects slower growth in the labor force—a trend that will continue as the U.S. population ages. Taking that into account, we might assume the economy expands 2% a year faster than inflation over the next 10 years. If inflation is also 2%, that would put nominal GDP growth at 4%.

Will corporate earnings also grow at 4%? That question triggers three others. First, will earnings per share grow slower than overall corporate earnings, as companies sell shares to finance growth and issue stock options to employees? Historically, earnings per share have lagged behind overall corporate earnings by two percentage points a year. But over the past 10 years, shareholders haven’t suffered any dilution, as companies use spare cash to buy back stock.

Second, will profit margins contract from today’s historically high levels? We can only guess at the answer. Third, will earnings of U.S. multinationals get a boost either because they snag a larger share of foreign markets or because foreign economies grow faster than the U.S.? Both are possibilities, but—once again—we can only guess at the answer.

The upshot: We might assume that corporate earnings do indeed grow at 4%, but accept that it could easily be somewhat faster or slower over the next decade. Tack on today’s 2% dividend yield, and you would be looking at an estimated 6% annual total return, or four percentage points a year faster than inflation.

But this assumes that stock prices climb along with earnings per share. Will they? Share prices today are richly valued relative to corporate earnings, which is worrisome. But they’ve been richly valued for much of the past quarter century, so maybe investors shouldn’t be concerned.

Vanguard Group founder Jack Bogle likes to distinguish between the market’s investment return—corporate earnings growth plus dividends—and its speculative return, which is changes in the value put on earnings, as reflected in the market’s price-earnings ratio. The dilemma: To come up with a prediction for 10-year returns, we need to speculate on how speculative other investors will be.

But don’t despair: As we lengthen our time horizon, changes in P/E ratios become less important and instead the market’s return is increasingly driven by the combination of earnings growth and dividend yield. In other words, if you have a truly long time horizon, you have a reasonable shot at notching something close to 6% a year, and that 6% should be comfortably ahead of what you could have earned with bonds.

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