Alpha Power Investing Newsletter

December 16, 2009

The 10% Fantasy

Ask most investors what they expect from the stock market over the next five to ten years and you're likely to hear "10%" or more.

While this number is greatly reduced from the fantasies of ten years ago, when investors routinely expected 15% - 20% returns forever, the probability of achieving it is virtually nil.

The investment advisory business is mostly to blame for this popular misconception. The market, they say, has delivered about a 10% return historically and from this, they make the unwarranted inference that those returns are in the cards for the average investor "over the long-term".

Yet here is the plain unvarnished truth: Starting from today, the market's long-term return will never get above 10%: not in five years, ten years or fifty years.

The data which supports the 10% model is derived from the work of Ibbotson and Sinquefield, who begin their computations from 1926. This starting point is vital to returns, because historical returns vary widely depending on starting valuations and dividend yields.

At the beginning of 1926, the price/earnings ratio of the S&P 500 was 10.4, and the dividend yield was 5%. In other words the market was cheap. Today, the normalized price/earnings ratio is 18 and the dividend yield is just 2%.

This puts today's market at about the same valuation as 1965 - which led to a 17 year range-bound market returning about 3% annually in nominal terms, -2% annually in real terms. In other words, today's market is expensive.

Earnings growth will not help the equation. Long-term earnings growth is pretty constant at about 6% annually. Profit margins, which have been elevated recently, are also mean-reverting, which means that they cannot be counted on to improve returns over the long-term. The only force capable of providing a 10% return over the long-term is expanding valuations. In other words, investors in the future will have to routinely value stocks much higher than today - about double, in fact.

This is well-nigh impossible. First, there is the historical fact that over the past 200 years it has never happened. The boundless enthusiasm of investors went over the top in 1999 when the S&P 500 was priced at 39 times earnings - the highest in history. But it was a fleeting moment, caused by an emotional herd of Johnny-come-lately's who wanted in on a bandwagon that they knew nothing about.

Next, the stock market is a reflection of human emotions and, as such, is a natural roller-coaster. The wish for 10% returns starting from today requires that the emotional state of future investors be one of constant and supreme optimism. Plainly impossible.

Finally, there is the historical fact that all long-term bull markets end highly expensive and then drift for years in a range-bound pattern until stocks are dirt cheap again. The past ten years are the latest example of this historical necessity. The S&P 500 has returned a grand total of 1.5% over the past decade. After inflation, the total return is -30%.

Investors may reasonably expect 10% or better long-term returns from the market when stocks return to 1926 valuations - 10 times earnings (or less) and 4% - 5% dividend yields (or more). The funny thing about this is that when that time arrives, hardly anyone will believe it.

Let's face it, stocks cannot be cheap when the average investor expects 10% or more from the market. Cheap markets require wide spread pessimism and disillusionment. Until that time arrives, successful investors will employ disciplines that are designed to harvest gains and keep them.

Jerry Minton, Ph.D.

© 2009 Alpha Investment Research Inc.
Alpha Power Investing Newsletter Archives