Appendix I
Some Thoughts about the Current Stock Market as 2010 Begins
Today, it’s hard to imagine the incredible ebullience in the stock market in 1999, when the first edition of Common Sense on Mutual Funds was published. Perhaps the best example was an op-ed essay in the Wall Street Journal by journalist James K. Glassman and the American Enterprise Institute’s Kevin A. Hassett, which was later turned into a book entitled Dow 36,000, and published a few months after own my book, in late 1999. The Dow Jones Industrial Average was then at a level of 10,273. The Dow would go on to reach a high of 11,722 in January of 2000, only to tumble to 7,286 by October 2002, rising again to a new high of 14,164 in October 2007, before the bull market evaporated. The Dow would plummet to 6,547 by March 2009, recovering to 10,000 at this writing in the autumn of 2009.
The 36,000 level now seems like a pipe dream. But of course the Dow will one day get there. For example, if earnings of the 30 companies in the Industrial Average grow at the historic (nominal) rate of about 5 percent per year, and stock prices rise at the same rate (an assumption, not a prediction), the Dow would in fact reach 36,000 28 years hence, in 2037, nearly 40 years after the arrival time contemplated by Glassman and Hassett. (Indeed, in their article they suggested that the Dow, then trading at 25 times earnings, could safely support an immediate doubling in price to 50 times earnings.)
Of course I had no choice but to challenge these absurd projections. “I am not willing to concede,” I wrote in the 1999 edition of Common Sense on Mutual Funds, “that stocks deserve no risk premium.” Simple logic left me “strongly concerned about the course of future stock returns,” and I suggested that future nominal stock returns might average 5 to 8 percent annually during the coming 10 years. Respected money managers Gary Brinson and Jeremy Grantham expected stock returns of 7 percent and 3 percent respectively during that period, roughly parallel to my own expectations.
In the, well, “irrational exuberance” of that bull market era, these forecasts were considered absurdly low. But the fact is that all three of us proved to be more optimistic than the reality that would follow. Returns on stocks during the decade that followed turned negative, at about minus 1.5 percent per year, the second-lowest decade-long market return of the past two centuries. So we three contrarians were right to forecast a dramatic drop in returns from the 17 percent average of the prior two decades, even as we were wrong in our failure to predict that returns would turn negative.
What we had in common was this conviction: In the long run, stock prices must track the underlying business fundamentals. I, for one, had failed to foresee the shocking deterioration in these fundamentals that would come nearly a decade later, notably the collapse of our financial sector in 2007-2009. In fact, reported earnings per share in the financial sector of the Standard & Poor’s 500 Index declined from $37.59 in 2006 to -$37.77 in 2008—a stunning 200 percent decline—while earnings for the remaining sectors of the S&P 500 Index fell by “only” 31 percent.
In the original edition of this book, I noted that in their classic Security Analysis, first published in 1934, Benjamin Graham and David Dodd had warned us about the stupidity of ignoring fundamentals such as dividend rates and asset values, relying instead on predicting what a company will earn in the future. Those words about the foolishness of “the new-era theory” had been expunged from later editions of Security Analysis. And that omission, I concluded in the final section of the 1999 edition, “may be the most ominous sign of all.” And ominous it proved to be.
Looking Ahead
In mid-2009 our economy remains in a parlous state. Our stock market has suffered the second-greatest plunge in its modern history, a 57 percent decline from its October 2007 high to its March 2009 low. By mid- 2009, it had bounced back by 57 percent. (Warning: a 57 percent drop followed by a 57 percent bounce does not leave the investor even. The combination leaves investors with nearly a 35 percent loss. Do the math!)
But lower stock prices, by definition, increase expected future returns. There are lots of ways to measure this effect, but let’s focus on just two. The first depends on the notion that the value of the stock market ultimately tracks the value of our economy. As shown in
Figure I.1, the market’s capitalization has typically been equal to about 63 percent of our nation’s gross domestic product (GDP). The ratio reached high points of about 72 percent in 1929 and 81 percent in 1972 (both, as it turned out, were market highs) before soaring to 184 percent in 2000 (another high), then declining, then recovering to 148 percent in 2006. After the tumble in stock prices (and a much smaller tumble in GDP), the ratio is 82 percent today. Message: stocks are far cheaper (although not necessarily cheap).
Another test (which Graham and Dodd would have liked) is the relationship between stock market prices and corporate book values (cash and receivables, plant and equipment, franchise value, research and development, etc.). As shown in
Figure I.2, the market prices of the stocks in the S&P 500 have, on average, totaled about $2.40 for each $1.00 of book value during the three decades for which data are available. That number had been reasonably steady from 1977 through the early-1990s, but it was to more than double to $5.42 at the 2000 high. (What were investors
thinking?) The price-to-book ratio fell for several more years to about $3.00 until it plummeted to $1.78 during the 2007-2009 plunge in prices. Same message as before: much cheaper, but not necessarily cheap.
FIGURE I.1 Stock Market Capitalization as Percentage of U.S. GDP (1929-2008)
FIGURE I.2 Ratio of S&P 500 Market Price to S&P 500 Book Value (1977-2009)
Future Investment Return
Now let’s look at future stock returns through the lens provided in Chapter 2. As we look ahead, we start with investment return, consisting of (1) the current dividend yield plus (2) future earnings growth. The dividend yield is pretty much a known factor, for dividends from corporate America have risen over time, and are rarely cut sharply. That said, the 22 percent estimated decline in the dividend in the Standard & Poor’s 500 Index for 2009 would be one of but 10 significant (more than 10 percent) cuts in the dividend during the past century, and one of the three sharpest. (Please note that these are declines in dividends per share.)
Based on the projected dividend for 2009 of $21.97 per share, the yield on the S&P 500 is now about 2.1 percent, which is the first step in our fundamental analysis of investment return.
1 But please recognize that a 2.1 percent yield is the equivalent of paying $47 for each dollar of dividends, a price that is nearly double the long-term norm of $26, albeit only about one-half the historic high of $87 in 1999. (See
Figure I.3.) Since dividend yields constitute a critically important part of our equation for ascertaining long-term value, this gap will inevitably take its toll on future returns relative to the past. (Over the past century, the yield has averaged 4.3 percent.)
As to future earnings growth, we know more about that than we might imagine. For corporate earnings have grown at approximately the rate of our economy, not merely over the long run (of course we’d expect that), but year after year. In fact, after-tax corporate earnings rarely exceed 8 percent of GDP, nor do they often account for less than 4 percent—a remarkably narrow channel, with an average of about 6 percent. As
Figure I.4 indicates, there is a powerful tendency of this earnings share of GDP to revert to the long-term mean. So when the earnings share of GDP made its record-setting leap to the 10 percent range during 2005-2007, we were being implicitly cautioned that corporate profits would soon decline. And so they did, from $1.44 trillion in 2007 to an estimated $970 billion in 2009.
FIGURE I.4 After-Tax Corporate Profits as Share of GDP (1929-2009)
Reasonable expectations suggest that, from these levels, earnings on the S&P 500 might grow at, or perhaps slightly better than, their long-term trend-line growth rate of 4.5 percent. (Note that this earnings growth rate is different than the 5.8 percent average share of GDP depicted in
Figure I.4.) So if we add that rate to the divided yield of 2.1 percent, we might be looking at an
investment return on stocks of 6 percent to 8 percent over the coming decade.
Future Speculative Return
The total return on the stock market itself, simplistically put, is the sum of this investment return plus or minus the market’s speculative return, defined by the annualized percentage change in the price-earnings (P/E) ratio for stocks (as described in Chapter 2, the percentage change in the number of dollars investors are willing to pay for each dollar of earnings). Forecasting the future level of P/Es might seem a simple exercise, for when P/Es are above 25, they have been far more likely to decline than to rise, and when below 10, they have been far more likely to rise than to decline.
But forecasting the long-term level of P/Es has proved far more complex than that. Why? Because in recent years, earnings have been managed by far too many corporate managers, and consequently overstated. It is not just financial engineering that distorts the earnings data (for example, when corporations assume future returns on their pension plans that are highly unlikely to be attained). It is also the difference, as I mentioned in Chapter 2, between operating earnings that reflect current business results and reported earnings, which reflect operating earnings minus (always minus) the earlier flawed judgments of management, such as deterioration in the value of the company’s assets or its balance sheet (banks in 2008, for example), write-downs of unwise and unsuccessful acquisitions, and the like. The differences are close to astronomical. During the past decade, operating earnings of the S&P 500 averaged $61 per share; reported earnings averaged $49, nearly 25 percent less.
Which figure to use? Wall Street strategists, ever looking to the bullish side of things, unerringly rely on the higher (operating) figure, the better to make the market look cheap. But the reality is that companies inevitably pay a steep toll for all of their bad financial decisions. So in the long run it is the lower (reported) figure that calls the tune. So if the average of the past 10 years’ earnings are used to calculate P/Es, investors are currently paying either $16 or $20 for each dollar of earnings.
2 The former number is above long-term norms but reasonable; the latter suggests that P/Es are likely to decline, leading to a negative speculative return during the coming decade.
But suppose that today’s corporate managers have learned from their ghastly mistakes of the past decade, and the next decade reflects—as did the decade of the 1990s—only a small gap between the two earnings signposts. Then P/Es could hold steady 10 years hence, or perhaps even ease upward. I’d guess, and it is only a guess, that from current levels some combination of slightly higher earnings growth and/or slightly higher P/Es and/or a swift recovery of corporate dividends could bring the nominal return on equities—including both investment return and speculative return—to between 7 percent and 10 percent during the decade ending in 2019.
Compared to What?
That’s just one man’s reasonable expectation, based, not on historical market returns, but on the sources of stock returns over a century or more, and does not take into account the “new normal” that I expect for the economy. We could well be facing a prolonged period of subdued economic growth, and it is difficult to know how much of that economic scenario has been built into today’s market valuations. What do other intelligent evaluators of market returns believe? One of the most accurate—and candid!—has been Jeremy Grantham, who is currently expecting a real return on U.S. equities of 3.5 percent over the next seven years, presumably equivalent to a nominal return of about 6.5 percent before inflation is taken into account, or roughly comparable with the lower edge of my projection.
One might ask, compared to what? Well, the 10-year U.S. Treasury bond is yielding about 3.7 percent in mid-2009. As noted earlier in this book, the current Treasury bond yield is an excellent approximation of its return over the coming decade. Treasury bills are yielding less than ½ of 1 percent, and two-year Treasurys aren’t yielding much more—about 1½ percent. So equities, in my judgment, are currently valued at levels that suggest they should remain a significant portion of most portfolios, with the asset allocation consistent with my suggestions in Chapter 3.
Financial market returns, to be sure, will also, as always, be shaped by powerful external forces. A troubled world, with wars in Iraq and Afghanistan and the ever-present threats of nuclear proliferation and terrorism. The Obama administration’s quest to stimulate the economy, and to deal with unprecedented deficits, including Social Security and health care. Global warming and the environment. A competitive international economy, with huge gaps in wealth between the richest and poorest nations, and so on. And these are but the “known unknowns,” with “unknown unknowns” beyond our horizon.
Yet despite these risks, if we want to achieve financial security, invest we must, carefully weighing the probabilities of what may go right and what may go wrong in the coming decade and beyond. But probabilities are only that—probabilities—and hardly certainties. Paraphrasing Robert Burns, “the best laid schemes o’ mice and men oft go wrong.” So please don’t forget that considering the probabilities of future returns only begins the decision-making process.
Decisions have consequences. If the consequences of being badly wrong about future returns would imperil your financial future, be conservative.
al Steer a careful course in a balanced investment program; seek the lowest costs; rely on highly diversified bond and stock index funds; demand tax efficiency; trade infrequently; be skeptical that past market returns and the performance of hot fund managers will repeat; and keep a long-term perspective. Then,
stay the course.
