Every year, top Wall Street analysts put their thinking caps on and try to forecast the upcoming year’s market return. The result of their analysis usually comes in the form of “price targets” which indicate where major indexes such as the S&P 500 are likely to be at year end.
These price targets are intended to provide clients and investors with an idea of what to expect over the course of the coming year. But not surprisingly, most of these forecasts miss their mark by a wide margin.
The reason for such high forecast error ultimately boils down to the dynamic global environment that we live in. The complex and interconnected nature of our financial system is so enormous that failing to accurately account for just one variable can cause major deviations from the expected outcome.
We’ve never been a fan of price targets for this reason, but we understand their role, acting as a guidepost for those who crave the simplicity of a single target. If you were lost in the woods, you’d probably take relief in seeing a signpost pointing toward civilization, even if you couldn’t necessarily trust it.
While price targets have little value themselves, what is valuable to investors is having a framework in which to view future returns. Especially from the perspective of retirement planning, we need a fundamental and pragmatic way to predict how our money will grow over time.
In this article we’re going to look at the key drivers of stock market returns, and provide an approach that you can use to get a feel for what lies ahead.
Much of our discussion today will focus around work done by John C. Bogle, Founder of Vanguard Group. Bogle has spent many decades trying to understand exactly what drives stock market returns, and his research has yielded a particularly useful method of explaining both past and future returns. The best part is that this approach is simple, intuitive, and provides a good framework for understanding the various sources of return that contribute to overall stock market performance.
The Three Components of Returns
According to Bogle, long-term returns in the stock market can be broken down into three components: Dividend Yields, Earnings Growth, and Speculative Returns. Together, these three variables account for the vast majority of stock market returns.
Let’s take each of these in turn, understand the role they play, and see what they’re currently telling us about future returns.
The first component that we need to examine is the current and expected dividend yield. For those who aren’t familiar with the term, dividend yield is a financial ratio that indicates how much a company (or group of companies) pays out in dividends each year, relative to its share price.
Dividends are a very important element of the return shareholders receive. In fact, on a pretax basis, dividends have accounted for nearly half of the total return for the S&P 500 Index over the last 25 years.
In terms of our forecast, dividend yields tell us what stock investors will earn in a given year if stock prices remain unchanged.
Right now the dividend yield on the S&P 500 currently sits at about 2%. Dividend yields have been following interest rates lower over the last few decades, and this trend is likely to persist. So for the dividend component of our forecast, we’ll stick with the 2%. Next up is earnings growth.
When we purchase a share of stock, what we’re really buying is a share of an earnings stream. As those earnings improve, the value of our stock rises. While stock prices tend to be volatile in the short-term, over a longer time horizon they have a strong tendency to track these increases in earnings. Thus, if we can anticipate earnings growth at the market level, we can determine how much stocks are likely to rise moving forward.
There are two ways to approach this. If we’re trying to get a feel for what returns may be like over the next 5-10 years, it makes sense to use some type of historical average. On the other hand, if we’re trying to make predictions for a specific year, or quarter, we need to look more closely at the current earnings environment.
For our purposes here, we’ll go with the historical earnings growth for the S&P 500, which has averaged about 4.7%.
Bogle refers to these first two components, dividend yield and earnings growth, as the “investment return” because they are based on actual company performance. The final component, speculative return, adds market psychology into the mix by examining price-to-earnings ratios.
Price-to-earnings ratios tell us what investors are willing to pay (in terms of share price) for $1 worth of earnings. This so called “earnings multiple” reflects investors’ appetite for risk, and changes over time.
Generally speaking, when the economy is healthy and earnings growth is expected, investors will be willing to pay up for earnings (the PE ratio will rise). On the other hand, as the outlook for the economy deteriorates, investors tend to become more defensive, causing the PE ratio to fall.
At the time of this writing, the S&P 500 is trading at roughly 18.5 times next year’s earnings. Our job, from a forecasting perspective, is to determine whether we believe this multiple will expand or contract in the years ahead.
If it expands, it means stock prices will rise even if earnings remain flat. On the other hand, if the earnings multiple contracts, there will be downward pressure on stock prices that will suppress overall returns.
Putting it All Together
Now that we’ve gone through the individual components, let’s combine them to get a better idea of what future stock market returns may look like.
If we take the dividend yield (2%) and add it to our expectation for earnings growth (4.7%) we’re left with an estimated annual return of just under 7%. Next, we need to factor in the speculative return component.
This part is more art than science, and is often where the bulk of the forecast error occurs. As you might have noticed, humans tend to be rather irrational at times, especially when it comes to money and investing. Do you think investors will be willing to pay more or less for $1 worth of earnings in the future? And by how much?
Since it’s difficult to forecast investor psychology, our best bet here may be to simply go with a range of possible outcomes. If the price-earnings ratio rose to 19 (an increase of roughly 2.7%), it would result in an expected annual return of about 9.4% (2% + 4.7% +2.7%) . On the other hand, if the earnings multiple fell to 18 (a decline of 2.7%), we’d be left with about a 4% return (2% + 4.7% – 2.7%).
One thing worth noting here is how drastic of an effect changes in market psychology can have on your returns. If something in the geopolitical environment causes investors to become scared, and they decide that paying up for earnings is not worth it, the resulting impact on the stock market and overall returns can be substantial. This can be the case even if the underlying fundamentals in the economy remain unchanged.
So there we have it. Based on the current dividend yield of 2%, estimated earnings growth of 4.7%, and no changes to investor psychology, the stock market is likely to return about 6.7% moving forward. And if market psychology does come into play, that return could be substantially higher, or lower.
So far, none of the figures we’ve discussed include the impact of inflation. In order to account for the loss of purchasing power that occurs over time, we must factor inflation into our estimate of annual stock market returns.
The Federal Reserve has currently set a 2% target for inflation. If we subtract this from our estimates, it appears that stocks are likely to generate about a 4.7% real return moving forward (assuming no changes in the earnings multiple). This is an important consideration because at the end of the day, your wealth depends not just on the value of your portfolio, but also on the general price level in the economy.
Understanding how to decompose stock market returns into their individual components can provide tremendous insight into future returns. We hope that by recognizing these three sources of returns, you’ll have a better lens with which to view stock market performance, and will be able to make better investment decisions moving forward.
And of course, if you don’t want to deal with managing your investments yourself, you can always follow our Investment Models.