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At Current Prices, Investors Should Have Mixed Feelings
The long rally has done wonders for my portfolio’s value. But it also means stocks are now more richly valued—and expected returns are lower. Unless you never again plan to add to your stock portfolio, you should have mixed feelings about the market’s heady gains.
Think about all the money you’ll invest in stocks in the years ahead, whether it’s with new savings, reinvested dividends or by shifting money from elsewhere in your portfolio. Wouldn’t you rather buy at 2009 prices than at today’s nosebleed valuations?
Indeed, I find it hard to get enthused about the prospects for U.S. stocks over the next 10 years. Consider the three components of the market’s return: the dividend yield, corporate-earnings growth and the value put on those earnings, as reflected in the market’s price/earnings ratio.
We already know the dividend yield: It’s 2% for the S&P 500. But big question marks hang over the other two components of the market’s return.
How Fast Will Earnings Grow?
Over the 10 years through mid-2014, the per-share earnings of the S&P 500 companies grew 6.3% a year, far ahead of the 3.6% nominal (including inflation) growth in GDP. But there are three reasons to fear slower earnings growth over the next 10 years.
First, the recent gains have been driven by rising profit margins. After-tax corporate profits rose from 7.9% of GDP in mid-2004 to 10.6% in early 2014. Without that boost, the S&P 500’s earnings would have lagged behind GDP growth.
Suppose profits remain at 10.6% of GDP, rather than reverting to 7.9%. Even in that scenario, investors likely wouldn’t be happy, because corporate profits would grow no faster than the economy.
That brings us to the second reason for worry: Economic growth may disappoint. Over the past 50 years, roughly half the economy’s 3% after-inflation growth has come from increases in the working population and half from productivity gains. But the labor force is now growing more slowly, as the entrance of new workers barely outpaces retiring baby boomers. The Bureau of Labor Statistics projects that the civilian labor force will expand 0.5% a year over the 10 years through 2022, versus 0.7% for 2002-12 and 1.2% for 1992-2002.
On top of that, many American families simply can’t afford to spend freely, either because they’re unemployed or underemployed or they remain handcuffed by hefty amounts of debt. That, too, could crimp economic growth.
A third reason to worry: Over the past 10 years, companies have bought back as much stock as they’ve issued. That’s unusual—and it may not last. Historically, shareholders have seen their claim on the nation’s profits diluted by two percentage points a year, as new companies emerge and existing companies issue new shares.
What Will Happen to Valuations?
Let’s be optimistic: Suppose after-tax corporate profits remain at 10.6% of GDP, both nominal GDP and overall corporate profits grow 5% annually over the next decade, and earnings per share also climb 5%, because companies continue to buy back stock at the same pace they issue shares. If all that comes to pass, stock prices would also climb 5% a year—if we don’t get any change in valuations.
That’s a big “if.” Consider the cyclically adjusted price/earnings ratio, which looks at share prices compared with average inflation-adjusted earnings for the past 10 years. The average for this P/E was 19.6 over the past 50 years and 16.6 over the past 100 years.
But since 1990, the average has been 25.3—which is pretty much where we are today. A bullish interpretation: Stocks have been richly valued for a long time, so perhaps we won’t see a big market decline and stocks can hang in there at current valuations.
Where does that leave us? Add 5% annual share-price gains to the 2% dividend yield, and you’re looking at a 7% total return over the next decade, while inflation runs at maybe 2% or so. And that, I would argue, is a scenario where everything goes right.
My hope: We get a 25% decline in share prices. That would make the market more reasonably valued and provide a buffer against disappointment—and I’d have greater confidence that my next stock-market purchase would collect a decent long-run return.
