The Sober Long-Term Outlook For Annual Stock Returns: 5%

| About: SPDR S&P (SPY)

Most in the investing community are perpetually wrapped up in shorter-term news stories. How could we not be?

Europe is seemingly always on the brink, we are bombarded with weekly updates on how slowly the US economy is growing, and a new crisis always feels near.

When it comes down to it though, most of this is just noise. Most investors don't have the skill or even desire to be a news-event trader, quickly entering and exiting positions based on headline risk. And when we consider that most investors simply want to grow their capital at a reasonable rate of return, trading is unnecessary.

Why? On a long-term basis, stocks overwhelmingly trend upwards. This is why it's so difficult to be a short-only trader; you're betting against the underlying trend of upward movement in stocks.

Take a look at the long-term trend:

Click to enlarge

David Einhorn says that he likes his hedge fund, Greenlight, to be more exposed to long positions than short because he wants to be a part of the trend that stocks rise over time.

As a result of the day-to-day hype, sometimes we forget to look further out into the future. I've read a few pieces on forecasting long-term stock gains, but I'd like to make this one as formulaic as possible:

Long-term stock returns = US GDP growth + Inflation + Productivity gains

I think this is a fair equation. Over time, stocks follow earnings. Average stock earnings track GDP growth, earnings take into account annual inflation, and productivity gains add to earnings by reducing costs.

Keep in mind this breakdown tells us about forward equity earnings, so we'll have to add back in dividends later, which are currently 2%.

Now that we have three variables, I'll give my estimates and rationale for the long-term figures.

GDP: 2.5% annual growth.

Since the US was founded, US GDP growth has averaged almost 3.5%. US GDP Growth has averaged 3.30 since 1880, and 3.18% since 1950. The results, over a very long-term time-frame (several decades), are very similar. We have generally seen real GDP growth come in a little above 3%.

Since 1990 however, US GDP has averaged less than 2.5% annual growth. This surprised me a bit; although we've been through a few recessions, one of which being the worst since the 30s, the technology boom of the late 90s was revolutionary and brought cost structures way down.

While we can't predict catalysts going forward, I expect the US to benefit from increased utilization of our natural gas reserves and shale oil findings. Additionally, looking several decades out, the potential for astonishing findings in renewable and sustainable energies is exciting, and the same goes for agriculture.

Computers are getting faster and more efficient, and this should help us improve our traffic grids. Companies like Ford (F) are working on vehicles that automate certain aspects of the driving process, with an ultimate goal to have cars "talking" to each other on the roads and efficiently moving traffic.

We are operating in the aftermath of a major credit-induced recession, so it will take some time to achieve annual GDP growth closer to 2.5%. I've seen estimates cite 2017, 2019, and 2022. The reality is that while the United States' private sector has deleveraged far quicker than most other developed nations, it still has some time before it will return to balanced levels. Additionally, the US government will at some point have to reduce its own debt levels, largely inflated from the private sector debt it was so willing to shoulder. This deleveraging will continue for quite some time; a decade sounds about right to me.

It appears that in times of deleveraging like this one, we oftentimes see a few temporary recessions and a few periods of above average growth, but a tendency towards about 2% growth. I suspect that dynamic will continue for about a decade, at which point we should start to see growth closer to 2.5%.

In sum, as a mature economy, we are likely to average annual GDP growth over the next several decades under 3%. 2.5% appears to be a good midpoint.

Inflation: 2.5-3.5% annual growth

There are legitimate concerns about the growth of our money supply. M2 just hit $10 trillion, and though money velocity is still in decline, it will not remain so forever. I do indeed worry that the unprecedented flood of cash is like a bunch of fireworks near an open flame; they're likely to go off. Now, whether or not the Fed will be competent enough to recognize inflationary potential before it's realized is beyond prediction, but it may not matter.

My feeling is that the Fed is essentially useless, and the work it does has a far weaker impact on the real economy (over the long-term) than it thinks it does.

Though banks are sitting on record excess reserves, money velocity is at historic lows. Additionally, a large portion of the growth in M2 was a result of repairing financial institutions' balance sheets. Of course, this has another consequence (as does everything): Too Big To Fail never ended.

Over time, inflation has typically been between 2 and 3%. I expect the next few decades to bring us inflation closer to 3.5%, given today's unprecedented reflationary policies and increasing near-term commodity shortages.

Productivity Gains: 1%

Productivity gains are defined as follows: a net increase in work output. In other words, doing more with less. Developed economies have been averaging about 1% in the past few years, with a general downward trend over the past several decades.

Alternate Factors

By taking the midpoints of my estimates, we are left with a prediction for about 6.5% annual earnings growth, or about 3.5% adjusted for inflation. Including dividends of 2%, total long-term return is expected to be around 8.5%, or real returns of 5.5%.

Based on the Shiller P/E, which is far more reliable since it annualizes earnings over the past decade, the S&P 500 (SPY) is trading at 22.08, giving investors an earnings yield of about 4.5%. The average P/E is 16.43, giving investors an earnings yield of a little over 6%; almost 9% if you add back historical dividends, which is in-line with historical equity appreciation.

Given today's current earnings yield of 4.5%, we are left with a figure that is nearly the exact same as my breakdown for forward equity returns. This makes sense, since the value we place on a company's earnings takes into account how those earnings are distributed (in the form of dividends). In other words, current earnings yields take into account the dividend component of equities.

Conclusions

Stocks are slightly expensive on an annualized basis, and when we breakdown likely components that are essential to long-term equity values, this view is corroborated.

As opposed to the 8% real returns that investors have typically received, my long-term forward view is for about 5% real returns.

This is still pretty solid, and when one considers the current total (earnings + dividend) yields on some today's stocks, there is plenty opportunity to outperform markedly.

For example, Becton Dickinson (BDX), a medical supplies company I have recommended in the past for DRIPs, offers a total yield of 9.67%. The company has an entrenched business model, stable cash flows, and a growth catalyst in that revolutionary medical supplies products are in high demand.

Disclosure: I am short SPY.

Additional disclosure: Short via puts. My short position is reflective of my short-term trading outlook for the market.