Do You Expect Single-Digit Stock Returns?
What do Buffett, Bogle, and Gross all agree on? Low stock returns.
If you’re wondering what stocks will do over the next few years, don’t ask me--or anyone else, for that matter. No one has found a successful formula for predicting the stock market. But if you’re wondering what a prudent investor should expect from stocks over the next five or 10 years, I’ll give an emphatic answer: not much. I'm in good company: Warren Buffett, Jack Bogle, and Bill Gross all agree with me. But more on that below.
Fewer 5-Star Stocks
I base my answer in part from a simple glance at our stock star ratings. A while back, I wroteabout how the number of 5-star stocks was shrinking. It still is. Whereas we rated more than 100 stocks 5 stars when the market was in the dumps in mid-September--remember, 5-star stocks are those we think are at least 30% undervalued--we’re now down to just 22. According to our analysts, whose forecasts of sales growth and profit margins form the basis of our star ratings, bargains are scarce.
Overpriced stocks, on the other hand, abound. As of Monday, we rated 79 stocks 1 star, meaning we think they’re at least 30% overpriced. Roughly speaking, we rate the biggest 500 companies in the United States, so it’s a pretty good sampling of the market. Here’s the complete breakdown.
The reason the stars are important is simple: Valuation is crucial for the future returns of stocks. If I buy stocks when their prices dip below conservative estimates of fair value, I stand a good chance of doing well over the long term. If I buy stocks that are overpriced, by contrast, I’ll do horribly, as many an investor has learned in the aftermath of the technology and Internet bubbles. (Pat Dorsey runs through the math of buying cheap stocks in one of his Tech Bytes columns.) That’s true even if I buy the stock of a great company. If I pay too high a price--which we think would be the case with 1-star or 2-star stocks--I stand a good chance of doing poorly regardless of the quality of the company.
The second reason I’d expect little from stocks is simple math. Jack Bogle, Warren Buffett, and others use a variation on a simple formula to calculate expected returns. As Bogle said at a Morningstar conference two years ago, "The mathematics of making money in the stock market is simple. It comes out of investment return and speculative return." Put into an equation, it looks like this:
Expected Stock Returns = Investment Return + Speculative Return
Expected Stock Returns = (Earnings Growth + Dividend Yield) + Change in P/E
The investment return comes from earnings growth and dividend yield--two factors that depend on the profitability of corporate America. So, for example, if U.S. companies were to increase earnings at 6% per year, and the average dividend yield was 2%, the investment return on stocks would be 8%. A lot of smart folks figure this--or something close to it--is a reasonable guess of the annual investment return in the next decade. (For more on these smart folks, see the "read more" section below.)
The speculative return, on the other hand, is more slippery. That’s because the speculative return depends on how much investors are willing to pay for corporate earnings. In other words, the P/E ratio. During the 1990s, the P/E ratio expanded from about 15 to 30, contributing mightily to stock returns. What will the P/E ratio do over the next 10 years?
It’s impossible to say, although it’s hard to imagine it going from 30 to 60, which is what it would take for us to repeat the 1990s’ bull market. Those P/E ratios soared thanks to market speculation and a dramatic decline in interest rates. (The lower interest rates, the more valuable stocks become.) If you expect stocks to return more than the investment return, you have to implicitly believe something similar will happen over the next 10 years. And that’s an intellectually difficult wager to make.
Bill Gross, one of the best bond-fund managers around, takes a stab at predicting the speculative return in a recent article. His argument is this. When inflation is low, as it is now, P/Es are high. He bases this not so much on theory as on a simple glance at the historical relationship between the two variables. Because inflation is unlikely to go lower, he argues, P/Es won’t get much higher. So according to Gross, the return we can expect from stocks will come solely from investment, as opposed to speculative, returns. He pegs this investment return at 5%--4% from earnings growth and 1% from dividends.
The exact estimate of future returns isn’t crucial. Warren Buffett, in a speech given in July and revised and reprinted in the December issue of Fortune, said that 7% (after costs) was a reasonable return to expect. What’s important is that some of the best minds in the business--Buffett, Bogle, Gross--expect single-digit stock returns in the aggregate. There’s nothing wrong with that return. It’s still perfectly respectable. But if you’re expecting juicier returns, you’re likely to be disappointed.
Can you do better than the aggregate? The only way is to buy undervalued stocks--stocks that the market has mispriced. That’s easier said than done, of course. But as Buffett says in the Fortune piece, "People are habitually guided by the rear-view mirror, and, for the most part, by the vistas immediately behind them." If you pursue a disciplined strategy of buying when others are most pessimistic--when everyone else is looking in the rear-view mirror and giving up on stocks--you better your chances over the long term. At the very least, such a strategy keeps you out of speculative, overhyped stocks that have cost so many investors so dearly.
There’s a wealth of great material on the topic of expected stock returns. Here’s just some of it.
"Warren Buffett on the Stock Market", Fortune Magazine
"Mr. Buffett on the Stock Market", Fortune Magazine
Larry Swedroe, "Risk and Expected Return"
Richard Ferri, "Investment Survival in a Single Digit World"
John Campbell, "Forecasting US Equity Returns in the 21st Century" (Note: The worksheet is available as a PDF file. You will need Adobe® Acrobat® Reader® to view and print it.)
Finally, we’ve had some lengthy threads in the Conversations area of Morningstar.com on this topic. (That's where I found links to many of the articles referenced above.) Here’s a conversation on what people think of one-year and 10-year expected returns, and here’s one discussing the paper by Campbell that I linked to above.