Over the prior ten years, S&P 500 earnings (GAAP) increased at an annual rate of 14% per year, representing the second largest increase of any ten-year period over the past 140 years. Someone asleep for the past decade might awaken, read this news and assume he is rich. Obviously, our refreshed friend would be sadly mistaken. Despite a stellar earnings decade, the S&P 500 index generated an annual total return of just under +3% in nominal terms, but only +0.3% after inflation. In other words, the real wealth of investors' stock holdings barely budged. What happened?
The paradox of the past decade is attributed to the starting point used to calculate earnings growth and returns. A decade ago, stocks were trading at an astonishingly high P/E of 47 times GAAP earnings and 30 times operating (non-GAAP) earnings. At that time, the technology stock bubble was in the process of deflating and overall corporate earnings had reached a bottom. Fast forward to the end of 2011, earnings reached an all-time high (GAAP earnings are over 3.5x higher and operating earnings are 2.5x higher), but the S&P 500 index was only 10% above its close from a decade ago. As a result, the market ended last year with a modest P/E of 13.
Source: Robert Shiller, Freeport Investment. Returns are based on average monthly stock prices.
What are the lessons here? First, valuation clearly matters. When the market P/E reaches excessive levels (i.e., two standard deviations or more from the mean), subsequent market returns are always very weak, and these corrections often take place over many years. Second, dividends matter. In fact, they matter a whole lot. As noted in the beginning of our report, over the past decade the S&P 500 index generated an annual total return of 2.8% in nominal terms and +0.3% in real terms. However, excluding dividends, the nominal and real returns drop to +0.8% and -1.6%, respectively, per year. Further, dividends are generally a good hedge against inflation, a risk we see over the next five-plus years.
Dividend stocks are not a fad. Companies with a consistent track record of dividend growth should represent an important part of any investor's portfolio, whether you seek total returns or yield. Some of our favorite dividend payers, which we own in the Freeport Intrinsic Value Portfolio, include Cal-Maine Foods (CALM), Ensco PLC (ESV), H.J. Heinz (HNZ), Johnson & Johnson (JNJ), Coca-Cola (KO), McDonald's (MCD), Microsoft (MSFT), Procter & Gamble (PG), Wal-Mart (WMT) and Exxon-Mobil (XOM). Each of these companies have strong balance sheets and generate impressive cash flows, so we expect dividend payments to continue to grow at a healthy rate.
You may wonder when the highest 10-year earnings growth period occurred. Using a fantastic database of monthly data compiled by Yale's Robert Shiller, earnings grew at an astonishing 16% annual rate from June 1946 to June 1956. During that 10-year period stocks also gained 16% per year, well above the long-term average of almost 9%. Indeed, that was one great decade for investors.
Given the abysmal returns over this past decade some may assume (or hope) to see above-average returns in the coming years. After all, history proves that stock returns mean revert over time. Periods of above-average returns are followed by below-average periods, and vice versa. However, this scenario assumes corporate earnings continue to grow at an above-average rate. Unfortunately, this is virtually an impossibility given where corporate net margins are today.
Sources: S&P, Freeport Investment.
Some market observers note that today's modest market P/E (~13) is cheap compared to the historical average (~15). This may be so at first glance, but we believe the market correctly recognizes that the current S&P 500 net margin is unsustainable (Figure 2). More specifically, the valuation picture changes when adjusting earnings for (lower) normalized margins. This is the assumption we use for our 10-year forecast (2011-2020) for stock market total returns of 5.6-6.1% per year (3.1%-3.7% in real terms). The current P/E is also a function of systemic risks, such as the potential for a deep and protracted European recession, a country seceding from the European Union, a slowdown in emerging market growth (China in particular), and an inept U.S. Congress.
Investors anticipating significantly higher returns could be greatly disappointed. As Research Affiliates' Robert Arnott recently noted, "People are expecting the markets to do their saving for them by delivering a high return. That's just not realistic." Hence, we urge investors with longer-term objectives to increase their savings rates to compensate for the possibility of lower returns.
For investors seeking current yield, we recommend portfolios comprising dividend-paying stocks and investment-grade bonds, the latter which includes U.S. Treasury, U.S. agency and domestic and foreign corporates. We further recommend investors limit bond holdings to intermediate-term and short-term maturities. Long-term bonds could suffer losses if interest rates rise in the coming years. Thus, managing duration and credit quality are critical to capital preservation.