At
social gatherings, when the question comes around to what we
do for a living, the next question after that is almost always
either: “What should I invest in now?” or “Where
is the stock market headed?”
Our answer, to the first question, “It depends,” never
seems to fully satisfy the questioner. Yet, it is the right answer.
In fact, it depends on a lot of things. Perhaps most importantly,
it depends on what the questioner already owns. Does their current
portfolio have an appropriate asset allocation? Are they properly
diversified, or are there concentration risks and portfolio overlap
issues? There are other issues as well: Why are they investing;
what is their objective? Are there tax considerations or cost issues?
What about their investment experience level?
In an environment of uncertainty (and one thing we are certain
about is that the market is always uncertain), the reply “it
depends” is certainly correct.
In the case of the second query, we’re not so certain. Our
expectation of how the stock market will perform over any short-term
time frame is really more of a guess, an educated guess to be sure,
but essentially it is still a guess. That’s why we believe
that balanced, diversified portfolios composed of different assets
and different managers make sense for most investors.
We do have an opinion on the markets, of course. We digest a lot
of outside research, and we analyze large amounts of data in the
course of our own research. Armed with that knowledge and our experience
as investors, we tilt your portfolios towards those exposures we
believe will provide superior risk-adjusted performance. While
we think the odds are in our favor, rather than make concentrated
bets, we still diversify because we know we could be wrong.
Longer-Term, Expected Returns Are Driven By Three Factors
While no one can accurately predict short-term stock performance,
a framework for expected stock market returns over multi-year
periods can be developed as a useful guide in formulating a longer-term
asset allocation strategy. We’ve covered this ground before,
but let’s review the building blocks of stock market returns.
Dividends
The first component of expected stock returns is current income
or dividends. Currently, the broad U.S. stock market (S&P
500) has a dividend yield of just under 2%. This compares to
a long-term average dividend yield of approximately 4%.
Earnings Growth
The second, and generally most important component, is earnings
growth. The historical average rate of growth in corporate earnings
is 6%. Not surprisingly, over the long-term, the growth rate of
corporate earnings closely tracks the growth rate in the economy.
However, globalization has made the growth of foreign economies
an increasingly important factor as well. The first quarter of
2007 is a good example. While nominal U.S. GDP growth was just
under 5% (0.7% ‘real’), first quarter S&P 500 operating
earnings were up 8%+, aided by strong growth in foreign earnings.
Robust global growth has benefited U.S. companies and their stocks,
and will likely continue to do so.
Valuations
The last building block in creating an expected return for the
stock market is the valuation (P/E ratio) the market assigns to
those earnings. Over the past 20 years or so, rising P/Es have
been a positive source of stock market returns. In more recent
years, however, we have seen P/Es contract, and largely for that
reason, the stock market has not gained as much as earnings growth
would have suggested.
A variety of factors play into valuations such as interest rates,
tax rates, transaction costs and regulation. Of course valuations
are also driven by so-called “animal spirits.” The
emotions of greed and fear can push valuations to extreme levels
in either direction. However, historically, when valuations have
reached extremes, they have eventually reverted back to more normal
levels. The Internet boom in the late ’90s is a recent example.
Where do We See These Factors Today
Dividends have been below 2% since 1997 and we expect them to remain
in that range for the next several years.
The last several years have been extraordinary ones for earnings
growth. Up until the first quarter of this year, S&P 500 operating
earnings had expanded at double-digit rates for 18 consecutive
quarters. As noted, last quarter earnings growth slowed to 8% and
Standard and Poor’s projects earnings further slowing to
6% in the second quarter and 2% in the third quarter.
We think a deceleration in earnings makes sense given that the
housing sector doesn’t appear to have stabilized yet. And
given that earnings have grown above their historical average in
recent years, one could argue for something less than 6% earnings
growth over the next several years. But for the purposes of building
a long-term stock market return expectation, we will use the long-term
average earnings growth of 6%.
Our view on valuations going forward is basically neutral, i.e.
on balance we expect no change in P/Es. However, if we were forced
to pick direction, we would give a nod to modestly lower P/Es in
the years ahead. Valuations remain higher than their long-term
averages which makes sense given that the combination of interest
rates, tax rates, transaction costs, and regulation also remain
low relative to their long-term averages. But the combination of
those factors seem more likely to go up than down given the current
political climate, and valuations have been trending down of late.
Adding It All Up
Let’s add it all up. A dividend yield of around 2%, plus
earning growth of 6% with no change in valuations adds up to an
expected return of around 8%. This is less than the average return
for the S&P going back to the 1920s of 10%, but actually higher
than the 7.1% the S&P 500 has returned over the last 10 years.
Factoring In Inflation
Of course, in investing your money, we are not just looking at
gross or “nominal” returns but your returns after
subtracting inflation or “real” returns. The long-term
inflation rate is about 3.4%, so the real long-term stock market
return is around 6.6% (10.0% minus 3.4%).
Current measures of inflation are a mixed bag. There are a variety
of measures to look at and multiple time frames. Currently, the
Consumer Price Index (CPI) is at 2.7%. Core CPI (CPI less food
and energy) is 2.2%. In terms of market expectations for inflation,
by comparing the yields between regular Treasury bonds and inflation-linked
Treasury bonds we see that investors think inflation is likely
to be around 2.5%. All in all, our best guess is that inflation
is likely to remain in the neighborhood of 2-3%.
If inflation is 2.5%, then our expected real return for stocks
is approximately 5.5%. While that is under the long-term average
real return of 6.5%, it isn’t a poor return.
For sake of comparison, the historical real return for long-term
bonds is in the neighborhood of 2.5% (again for stocks the average
is approximately 6.5%). With current Treasury yields at 5.0% and
inflation around 2.5%, the expected real return for bonds is basically
in line with long-term averages.
Key Implications for Investors
There are a couple of important implications from all of this.
First, stocks should still provide superior real total returns
to bonds (5.5% to 2.5%), although their advantage over bonds
may be less than normal (6.5% to 2.5%). Second, since the expected
real return differential between stocks and bonds is less than
in years past, owning bonds to help lower overall portfolio risk
and provide a more attractive risk-adjusted return makes even
more sense.
Our objective is to build client portfolios that include a broad
range of assets, including alternative investments, with the goal
of delivering attractive long-term, risk-adjusted returns for an
appropriate level of risk – after costs, taxes, and inflation.
We may be able to achieve higher returns than the broad market,
but using the above facts and figures are helpful for financial
planning purposes.
Conference Call
On June 27th, we hosted a conference to provide an overview of
our current thinking on the economy and markets. For those who
missed it and might want to hear it, it can be found at: http://www.kobreninsightmanagement.com/conference_calls.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
