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Expect more modest gains in stocks over next decade

Updated: May 3, 2013 12:14PM

Originally published: June 17, 2004

What kinds of returns can you really expect from your stock market investments? Just a few years ago, there was a widespread belief that 15 percent or greater annual returns were relatively easy to achieve. These days, investors are wondering if the market will ever put together another string of winning years.

The answer is somewhere between the long-gone euphoria and the long-term pessimism of those who were burned.

From 1926 through 2003, the S&P 500 stock index achieved an average total return of 10.4 percent. (Total return includes dividends and price gains.) But for the period from 1982 through 1999, the average total return of the S&P 500 was an unprecedented 18.7 percent.

In fact, the three 20-year periods represented by the last three years of the bull market (1997, 1998, and 1999) were the highest-performing 20-year periods in stock market history.

Reality dawns in 2000

Then, in 2000, reality set in with a thud. A bear market wiped out $7.1 trillion in market value, and even the rally of the past two years hasn’t recouped those dollars for investors.

And now investors have some tough decisions to make. What can long-term investors reasonably expect from their stock market funds?

A new study by B. Grady Durham, president of Monticello Associates, an asset management consulting firm in Denver, gives some important insights into the 20-year bull market.

Durham points out that the 18.7 percent average annual return of the recent bull market is almost double the long-term rate of return. And where did those extraordinary returns come from? He breaks it down as follows:

Dec. 31, 1981 to Dec. 31, 1999:

Total return: 18.7 percent

Yield: 3.2 percent

Earnings growth: 6.6 percent

Valuation change: 8.9 percent

Yield refers to the dividend payout, which contributed 3.2 percent per year to the total return. Earnings growth is the traditional driver of stock investment returns, and that 6.6 percent is only slightly above the long-term trend line. It’s the 8.9 percent a year “valuation change” that catches your attention. Valuation change is simply the change in price/earnings multiples -- the ratio of stock price to company earnings.

Durham points out that when the bull market began in 1982, stock prices were close to an all-time valuation low, with P/Es at 7 times earnings. By contrast, he says, “By the time the great party ended, valuations had been pushed to more than 30 times.”

That’s all the more extraordinary, he explains, because historically these valuation changes have “zeroed each other out over time,” having no long-term impact on stock prices. Instead, the gains in equities have historically been based only on earnings and dividends.

That’s not what happened between 1982 and 2000. P/E multiples kept expanding. Durham’s conclusion: “The greatest bull market in U.S. history was purely a price-earnings multiple expansion game.”

And what does that mean for today’s investor? Currently the S&P 500 has a P/E valuation of 23 times earnings, and a dividend yield of 1.78 percent. Since the long-term average P/E of the S&P 500 is only 14.1 times earnings, there is reason to conclude that the stock market is still highly valued in historical terms. With earnings currently projected to grow between 4 to 7 percent annually, and a current yield of around 2 percent, it is logical to expect a stock market total return of between 6 and 9 percent over the next decade.

Yes, the stock market has defied logic before. But as Durham notes, that happened during an unprecedented 20-year period of declining interest rates.

Stocks become more valuable as low rates make alternatives less interesting. That explains the expansion of P/E multiples year after year as rates declined. Now, interest rates are on the rise. It’s hard to imagine stock multiples expanding and contributing to rising stock prices.

Payback time?

Maybe it’s payback time for all those bull market years. In the next decade or so, stock market return might be at -- or lower than -- the 10.4 percent long-term historical average.

That doesn’t mean you should give up investing in the stock market. It just means you’ll have to adjust your expectations to more modest returns. That’s the Savage Truth.

Terry Savage is a registered investment adviser, and appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast. Distributed by Creators Syndicate.

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