What's the Future for Stock Returns??

This blog post may come as a bit of bummer, but nonetheless, it is important that I write it anyways. The information that I will share below comes from Chapter 9 of Jack Bogle's book, "The Little Book of Common Sense Investing." The chapter is called, "When the Good Times no Longer Roll." In it he lays out his expectations for future stock market growth. Again, these are not proven predictions, since no one, even Jack Bogle himself, can predict the future. His expectations come more so as a caution to us, the Layman Investors, and serve as a reminder to us that nothing lasts forever. It is vital that we discuss and understand the concepts he's describing in this chapter. Let's begin

The Total Returns of the stock market can be split into two parts: Investment Return and Speculative Return. Investment returns can be broken further into two parts: Stock Price Appreciation and Dividend Yields. Stock Price appreciation is exactly what it sounds like--the price of the stock going up over time. Dividends, we talked about in a previous blog post (Dividends: to Reinvest or Not?), are quarterly payments companies share with their stockholders. If you need a recap on Dividends feel free to check out that blog post. Together, stock price appreciation and dividend yields make up Investment Returns. Investment Returns are driven by the fundamentals of businesses, i.e. businesses showing up day in and day out and doing their job to make goods and services and drive innovation (for a recap on this concept check out blog post: "I'm Going to Wait for the Market to Settle Down"). In the long run, most of the appreciation of the stock market is due to Investment Returns.

Speculative Returns, however, also have a part to play and depending on the time frame we look at they can have a larger or smaller impact. Speculative returns are calculated using the Price to Earnings Ratio (P/E Ratio). Whoa, what's that? Very simple. It's the price we, investors, are willing to pay for every dollar earned by businesses that we then earn as investors. For example, If a company has a P/E ratio of 5, that means I, as an investor, am willing to pay $5 to the company for every $1 it earns me. As you may have guessed, the higher the P/E ratio the more people are willing to pay out of pocket for every dollar earned by the business. This usually happens when people become overly optimistic, usually during a bull market. The lower the P/E ratio, the less people are willing to pay out of pocket for every dollar earned by the business. This may result in times of deep pessimism amongst the public, usually in times of a recession.

The "Earnings" part of the ratio is usually projected out into the future based on reports and analysis done by the company itself or by third party companies. This is why it's known as Speculative Return, because analysts are trying to project future earnings for the business, so they use their best guess based on data, modeling, and their own rationale. But remember as John Maynard Keynes stated: "It is apply to future indicative arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was." So, no one can really tell us what EXACTLY future P/E ratios will be, therefore no one can really predict what future Speculative Return will be, however, Jack Bogle rests on the side of caution stating, "both common sense and humble arithmetic tell us that we're facing an era of subdued returns in the stock market." But why?

He's looking at the hundred plus year history of Investment Returns (Stock price appreciation and Dividend Yields) and Speculative returns (P/E Ratios). The table below, taken from his book, shows us The Total Return on Stocks, Past and the projected future.

If we look at the stock market since the 1900, earnings growth accounted for 4.6% of the growth, dividend yield 4.4% growth (Remember: Those two put together equals Investment Growth of the stock market) and Speculative return was only 0.5%. On average the stock market grew at 9.5%. That's pretty good for someone who invested over a 100 years ago. If someone invested in 1974 until now, here's what they saw: an earnings growth of 5.5%, divided yields of 3.3%, and Speculative Returns of 2.9%. Wow! Why was the Speculative Returns so high!? Well, the 70's and 80's were a high time for stocks. Everyone wanted in and that boosted the P/E ratios (Speculative Returns) to record highs tripling them from 7.5 times earnings to 23.7 times earnings resulting in the 2.9% speculative returns. Since then, the P/E ratio has stayed relatively the same at 23.7 times earnings. This, according to Jack Bogle may represent "some combination of unbridled optimism, excessive confidence, exuberance, and hope, or a new reality" (95).

If we look at the next 10 years bar, we see that Jack Bogle has subdued his expectation of the P/E ratio sustaining 23.7 times earnings. Dividend Yields, as a whole, have gone down to 2%, earnings growth he expects to be 4% (which is equal to the expected nominal growth rate of the country's economy) and he expects the P/E ratio to therefore subdue to about 20 times earnings, a 2% drop, bringing the total return of the market down to 4%. That really sucks, but it still beats the next option of keeping your money in a savings account. When you tack on an expected inflation rate (for a recap read the blog post: Inflation) of 2%, the real returns of the market would be only 2%!!! That really blows, but remember this is one man's best guess. He is brilliant, but still he CANNOT predict the future. If P/E Ratios go up to 30 times earnings then we can tack on 1.5 percentage points, if they drop to 12 times earnings, then we subtract 7 percentage points.

What does this mean for the Layman Investor? Well, for now stocks are still a great investment to make especially through index funds. You can see how the low fees from Index funds really help you stay in the positive if the real returns of the market were to drop significantly due to subdued P/E Ratios. As long as Mutual Funds continue their high cost, hyperactive trading behavior, index funds will always win out even if stock market returns are subdued.

It is sad to think that the high times of stocks are behind us. Nothing lasts forever, but I would like to think that there is a silver lining to all of this and that is: as long as we keep educating ourselves we will have a chance to adapt to future circumstances. For now, investing in stocks through index funds is a great way to go because we can still grow our money at lower risk, lower cost, and keep more of our profits. Also we, as layman investors, can learn about the fundamentals of investing through index funds, so that when it comes time to adapt to new circumstances in the future, we're ready. Although there are other investment vehicles available to us, i.e. Real Estate, Crypto-currencies, Life Insurance, etc., index funds are a great way to start learning the ropes of investing. So keep on keepin' on. Be mindful not to get over-confident or depressed. Leave your emotions at the door and stick to the fundamentals!

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