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Monday, October 03, 2005
Waiting For Average
Investors Insight Publishing
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This week's letter is from my good friend Ed Easterling of Crestmont Research in Dallas. Ed helped co-author a couple of Chapters in my book "Bull's Eye Investing" and that inspired him to write his own book. Ed's must read book, in my opinion, is called "Unexpected Returns: Understanding Secular Stock Market Cycles."
In this article Ed lays out why boomers will not see the average market returns of the past in their future. The "Buy and Hold" crowd will point to Ibbotson studies on long term returns and Markowitz's Modern Portfolio Theory as reasons to invest, but Ed explains how these two things can be used to mislead investors and that is why it is this week's Outside the Box.
- John Mauldin
Waiting For Average
The long-term average return from the stock market is 10.4%. As the earliest
baby boomers are now beginning to retire, they will be relying upon their
investments for income. The latest boomers have two more decades to compound
their savings into a retirement payload. At 10%, boomers young and old--so to
speak--have a good chance of a secure retirement. Yet, from 2005, what length of
time is needed to assure the long-term average return?
NEVER--investors from today will never achieve the long-term average return. Not
in ten years, twenty years, fifty years, or the seventy-nine years that
represent the most recognized long-term average return.
According to the 2005 Yearbook published by Ibbotson Associates, the long-term
average return from the stock market is 10.4% (pg. 29). Ibbotson starts their
long-term series of financial data in 1926 (pgs. 27, 201). Eight decades is a
long, seemingly credible period of time--why shouldn't today's investors
reasonably expect a similar return over the next one, two, or eight decades?
There are only three components to stock market returns: earnings growth,
valuation-level changes (i.e. the change in the P/E ratio), and dividend yields.
A discussion of these three components will confirm that a reasonable future
return assumption is less than two-thirds of the long-term average.
Before we look forward, let's look backwards for insights. Let's use the
certainty of history to explain the contribution of each of the components to
the long-term average of 10.4%. According to Ibbotson, earnings growth
contributed 5.0% to the long-term average (pgs. 178, 180). Since P/E ratios were
10.2 in 1926, the effect of the increase to 20.7 at the end of 2004 provided
0.9% to the long-term average (pg. 179). Finally, partially related to the
starting and average P/E ratios, the dividend yield averaged 4.5% over
Ibbotson's period of choice (pg. 180). Combined together, the compounded total
return (before transaction costs, fees, expenses, etc.) averaged 10.4%.
So looking forward, from conditions that exist at the starting point of 2005,
what are reasonable assumptions for the three factors over the next few decades?
To assist in the discussion, concepts and data from the book Unexpected Returns:
Understanding Secular Stock Market Cycles will be referenced.
First and foremost, we can eliminate the impact of significantly higher
P/Es--the level of valuation cannot be reasonably expected to double to 41 over
the next seventy-nine years. Given that we are near historical highs for the P/E
ratio (excluding the two bubbles during the past century), any further material
increase in P/Es in unrealistic. Past bull markets peaked with P/Es in the low
to mid 20s; there are financial reasons, explained in Unexpected Returns (pg.
155-161), that P/E ratios cannot be sustained above the mid-20s. Therefore, if
P/Es can at least be maintained at currently high levels, the best-case
long-term return is 9.5%, the long-term average of 10.4% less the 0.9% impact of
P/E expansion.
The second component, earnings growth, is closely tied to economic growth. Over
the past decades and century, as discussed in chapter 7 of Unexpected Returns,
earnings growth is closing related to Gross Domestic Product ("GDP"). GDP growth
is comprised of real growth in GDP plus inflation. Today, inflation is being
tightly controlled by the Federal Reserve Bank and is running below the
historical average. As a result, future nominal earnings would be expected to
grow at a slower rate than the historical past. Although it may not be much of a
change, a 1% slower nominal growth rate shaves almost another 1% off of the
potential return provided by earnings growth. Please keep in mind that if
inflation does increase, the resulting decline in P/E ratios will more than
offset the benefit to earnings growth. So with the more optimistic low-inflation
scenario, we're down to a best-case long-term return of 8.5%.
The final component, dividend yield, is directly and mathematically related to
the starting level of valuation--the P/E ratio (Unexpected Returns, pg.
103-105). In 1926, when the P/E ratio was close to 10, the dividend yield was
approximately 5%. At the current P/E of 20, the normalized dividend yield drops
to near 2.5%. The dividend policy and payout rates for companies do not change
as the result of the level of its P/E ratio. A company that generates $2 per
share will typically pay out $1 per share in dividends regardless of whether its
stock price is $20 or $40 (i.e. 10x P/E or 20x P/E). Yet the dividend yield when
the P/E is 10 will be 5% ($1 dividend on a $20 price), while the dividend yield
at a P/E of 20 will be 2.5% ($2 dividend on a $40 price). The effect of today's
valuation levels, P/E near 20, reduces the expected yield by more than 2% versus
the historical dividend yield. As a result, our best-case future long-term
return approaches 6%.
Of our three components in the future, two of them--earnings growth and dividend
yield--are good soldiers that will provide a fairly predictable contribution to
total return near 6%. The third component--changes in the P/E ratio--will
determine whether realized returns are near 6% or are much less. The trend in
P/E ratios significantly impacts multi-year returns. During periods when the P/E
increases, earnings growth is multiplied; whereas, periods of P/E declines
mitigate EPS growth. The result is periods known as secular stock market cycles.
From currently high levels, any decline in P/Es will reduce long-term returns
below 6%. The magnitude of the shortfall will depend upon whether the decline
stops at the historically average level or further declines to typical secular
market lows.
The discussion of the components for future returns is complete--all three parts
indicate below average returns in the future. Earnings growth will be lower than
average, unless inflation increases. Dividend yields will be well below average
as a result of current valuation levels. P/Es cannot contribute their past
benefits due to their currently high levels. Finally, a decrease in P/Es, due to
higher inflation or other factors, would offset the resulting modest gains in
earnings growth. In the aggregate, investors can expect that the long-term
return, based upon 2005 as the starting point, will be less than two-thirds of
the historical average. Once P/Es retreat to average levels, future long-term
returns from that point will increase. From now to then, investors would suffer
the effects of a P/E decline. And only when the starting point for P/Es is again
at 10.2 can investors expect that the historical long-term average return will
again be possible.
As a result of the current environment and conditions, investors have two
alternatives: reasonable expectations or blind hope. Unfortunately for the
boomers, historically average returns are not in the cards.
But What About Markowitz, MPT, & Your Stock Market Investments?
Modern Portfolio Theory ("MPT"), the model that acclaimed a Nobel Prize, should
come with a warning label. "Use with caution. It's only as good as your
assumptions." What did Harry Markowitz intend to impart with his ground-breaking
research and what are the implications given a reasonable view of future
long-term returns from today?
Harry Markowitz published his research titled "Portfolio Selection" in The
Journal of Finance during 1952. He led with: "The process of selecting a
portfolio may be divided into two stages. The first stage starts with
observation and experience and ends with beliefs about the future performances
of available securities. The second stage starts with the relevant beliefs about
future performances and ends with the choice of the portfolio. This paper is
concerned with the second stage."
Help! What about the first stage? What do you mean that the assumptions are OUR
responsibility?!!
It's been many decades since the article was first published. Many, many
'buy-and-hold" constituents have reiterated their mantra in concert with Dr.
Markowitz. But that isn't what he intended. Yes, investors should only be
rewarded for taking risks that can't be neutralized. Yes, stocks have more risk
than bonds and over time have realized higher returns. BUT, what if your
timeframe isn't 75 to 100 years and what if you are starting from a period of
relatively high valuations and the expectation of below-average future returns?
Please Dr. Markowitz, help me with my 10 to 20 year investment horizon. For
that, we can reflect upon historical 10 to 20 year horizons for your
assumptions. That is the first stage to which Markowitz referred--before MPT can
be applied to your portfolio.
Since 1900, there have been 86 twenty-year periods, the first was from 1900 to
1919 and eighty-five double decade periods thereafter. The results can be sorted
into two groups: those above the average and those below the average. Is there a
way to determine whether the next twenty years is likely to be a top half or
bottom half period? This would enable us to improve our outlook by using an
above-average or below-average return assumption.
One characteristic that is blatantly obvious for the two halves is the starting
level of valuation in the market as determined by the price/earnings ratio
(P/E). It's the bellwether measure of prices in the stock market. Almost
unanimously throughout the past century, when the P/E is above average,
subsequent returns are below average. As well, below average P/E's historically
delivered above average returns.
So since the current P/E is well above average, shouldn't the assumption for
Markowitz's model be below average returns? Wouldn't this be consistent with the
assessment of future returns provided earlier?
Markowitz gave us the holy grail to portfolio management; conventional wisdom
has forgotten or ignored the need to use appropriate assumptions--the essential
"first stage" of portfolio management. As Markowitz emphasizes, it is our
responsibility to use "observation and experience" to develop "beliefs about the
future performances." Although future performance of the stock market cannot be
predicted with certainty, through observation and experience we may be able to
at least refine the assumptions into above-average or below-average territory.
Based upon current market valuations, it is very likely that we're in the
'below-average' batters box and should include a below-average return assumption
for the next twenty years and even longer.
Oh no. Should we hang on to hope that this time will be different? Or should we
rationally include a scenario that presents below average assumptions to Dr.
Markowitz? Dear Dr. Markowitz, what should we do if the assumptions for stock
market returns are below average?
Ed Easterling is President of Crestmont Holdings
Conclusion
I hope you enjoyed this week's Outside the Box. To read more insightful
research by Ed Easterling, I highly recommend his book Unexpected Returns
(www.amazon.com).
Your not expecting long-term average returns analyst,
John Mauldin
JohnMauldin@InvestorsInsight.com
www.2000wave.com
October 3, 2005
Copyright 2005 John Mauldin. All Rights Reserved.
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