Thu, 13 Oct 2011
A reasonable estimate based on dividend yields, potential earnings growth, and current P/E ratios suggests a 7% annual return for stocks over the next 10 years, says the Vanguard founder.
Christine Benz: I’m Christine Benz for Morningstar.
I recently attended the annual Bogleheads Conference, and I had the opportunity to sit down with the event’s namesake, Jack Bogle. Jack is the founder and former chairman and CEO of the Vanguard Group.
Jack, thank you so much for being here. It’s always a real treat to talk to you.
John C. Bogle: Good to be with you again--especially at the Bogleheads meeting.
Benz: Right. This day is all about you, this week.
Jack, I’d like to talk about where you think stocks are currently. There's been some discussion about whether stocks are cheap right now or whether they're actually pretty fairly valued, if not slightly overvalued. What do you think is the utility of Shiller P/E? Some people have used that to debate stocks valuations currently.
Bogle: I like the Shiller P/E. I like the Shiller P/E for two reasons: One, it's focused on a longer period of time, not just on the moment, and that's very important thing to do because earnings can do all kinds of things in short periods.
Benz: So it’s cyclically adjusted.
Bogle: It’s focused on history and a lot of people compute these P/Es by looking at next year's earnings, which we'll see. We shall see.
And the other thing I like about it is, he uses reported earnings from companies and not operating earnings. All the Wall Street pundits use operating earnings. Why? Because they are higher than reported earnings. The difference between operating earnings is what the company does in its normal course of business, and we take away from that, in order to get to reported earnings, all the mistakes they've made in investments, bad decisions, changing past decisions, things of that nature. And so it is actually reported earnings that give you the true, long-term picture of the company itself.
So those two reasons, a long-term focus and the right earnings number and reliance on history, I go with Shiller. And by his numbers, I think he has about a 17 times P/E as the norm, and it’s around 21 times today. I wouldn’t regard this data, being data, as a major imbalance, but it would suggest the market is probably more or less properly valued, correctly valued, or maybe somewhat overvalued.
But I don't worry so much about that, because my analysis of market returns put together over years and years and years is, stock returns you should look at--not currently particularly--but for the long run, and for the long run, I use 10 years. And I have been doing this for a long time, and it's worked out marvelously well. You start with the current dividend yield and then you take the earnings growth, and add that to the dividend yield, and then you estimate what change you will get in the price/earnings multiple.
Now think about this for a minute, Christine. The dividend yield you know; today’s dividend yield is a known fact. Earnings growth tends to be very similar to the rate of GDP growth at around 5%, 6%, and that's nominal. So we've got to be careful about that. And P/Es if they are over 20, the odds are great that they will be lower at the end of the decade, and if they are under 10 or 12, the odds are they will be much higher at the end of the decade.
So we know much more than we think we know. And using that analysis, I'd say the 2%-plus dividend yield, let’s say a 5% or 6% earnings growth, let’s call it a 7% return, and maybe a loss of a point in a lower P/E, or maybe not. So putting it all together, you get around a 7% forecast outlook for stocks, which is not bad, because you are going to double your money, in nominal terms again, double your money over a decade if we are fortunate to get that 7% return. That's well below the historical norm, however, of 9%. And I think that's reasonable, if only because the dividend yield, a crucial part of this, is, over the long term, 5%, over 100 years, and now it's 2.25%. So that suggests lower returns in the future.
For bonds, we have to think about a very simple fact, and that is today's bond yield gives you a remarkable representation of the return you will get from that bond over the next decade. Now the benchmark bond yield, of course, is the 10-year Treasury, 10-year U.S. Treasury note, and that yield today is a little over 2%. It has been actually down in the 1s recently. So that looks pretty pathetic, although it makes stock returns look quite generous.
I don't think most people can afford to settle on a 2% bond return. That would be more or less ... I guess our Total Bond Market Index Fund is around 2.3%. So, a little better because it has some corporates in there, while it’s heavily dominated by Treasuries and mortgage-backed securities, maybe 70% of the index, 65% or 70% are in those super-safe, very short, mostly very short, maturity bonds.
So I think investors are going to have to be willing to go out a little bit longer in maturity over that 10 years maybe, and a little bit down in quality, maybe investment-grade-quality bonds, which is today, according to the press, I think this is a high number, but what I read in The Times every morning, is about 4.8% for a long-term investment-grade bond.
So I think you can put together a package of bonds without taking excessive risk that will give you maybe 3.5% return over the next 10 years. Well, the math is kind of fun because 3.5% will compound to a 50% gain on bonds, and as I mentioned 7% will compound to 100% gain on stocks. So, there are going to be a lot of bumps along the way and reasonable expectations are a long way from firm predictions, but I think the stock market seems about right today.
Benz: Okay. Well, Jack, I am talking to a lot of investors who are looking at what they think will be meager bond market returns in the future and saying I can't just index, I can’t just sit there. I need to be a little more active, maybe go with an actively managed fund. What's your take on that thinking?
Bogle: They should have their heads examined. Let me be honest about it. I mean the magic of the bond market fund--and it may be you should make a variation on the actual Total Bond Market Fund because of the heavyweight in Treasuries, but when you take a tenth of 1% out of that return for costs in an index fund or two-tenths of 1% out, that's a far cry from most bond funds, which charge nine-tenths of 1%. Can actively managed bond funds overcome that manager [expense] drag? They can't. And sometimes it looks like they can, and of course, the investment world being the investment world, someone is going to show you half a dozen bond funds that have outperformed the market.
I have great respect for Bill Gross, but he happens to be about, I think, 400-500 basis points behind the Total Bond Market Fund this year, because he didn't like Treasuries. He'd be the first to say he was wrong at least in the short-term, and I mean no disrespect for him. He is one of the great managers of all times and his [colleague], El-Erian, is also I think pretty terrific, but that can happen anywhere.
So you don't know. You've got to pick the manager. You've got to make sure you get the cost out of the equation, and ... the odds that you're making a losing bet are extremely high.
Benz: So it sounds like for fixed-income investors what you would advise is maybe use the Total Bond Market Index as an anchor, and then make some adjustments around the margins using very low-cost products.
Bogle: Yes, exactly.