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Owning Stocks Today 6% Annualized Is A Realistic Long-Term Expectation

|Includes: SPDR S&P 500 Trust ETF (SPY)

It seems like the end of the year is bringing them out in droves - there are a lot of articles about market level and future returns, some of them extremely pessimistic. Here's a chart summarizing my current thinking:

I started by doing a DCF analysis on E10 (10 year average earnings for the S&P 500 (NYSEARCA:SPY) as computed by Dr. Shiller). Assuming 4% growth ad infinitum, and an initial E10 of $80 (rounded from $79.29), I determined the relationship between expected returns and market level.

That methodology has one inherent flaw: the math assumes that the ending CAPE (or PE10) is the same as the beginning. That's not realistic. So I modified that by assuming that CAPE reverts to 22. The harmonic mean of CAPE from 1987 to the present is 22.58: I rounded down. The harmonic mean is intended to compensate for the very high ratios that prevailed during the tech bubble.

Another assumption that is built into the DCF method is that the shareholder gets the full benefit of company earnings, on an annual basis. This is strictly and literally true only if the company or companies pay all earnings out as dividends. But if the earnings are simply banked, they will appear on the balance sheet as excess current assets, which will increase the value of the shares involved.

And if management deploys the earnings in ways that increase value, compounding will work its magic. I feel as if just noting that the shareholder gains ownership of the earnings, however management may deploy them in the business, it's simpler to just treat them as received when earned.

Here's how I did the math:

Working with initial return expectations from 6.5% to 12%, I modified them as shown above to reflect my belief that the most realistic way of looking at it is to assume CAPE reverts to an average value. That's what you get in the chart that leads off the article.

Credibility Testing

I tested this method by looking at returns received by investors who started in December of 2004, 2005, 2006 and 2007, buying and holding the S&P 500 through December this year. According to the model, they should have expected returns averaging 6.05%. They received an average 6.57%.

An investor buying on 4/1/2009 would have been looking for 15.44% and would have received 15.6%. A brave soul investing in December 2008 would have looked for 13.5% and received 14.4%.

Finally, when CAPE is at 40, a number it exceeded during the tech bubble, this model says you could look for 1% very long term, after the market recovers. I didn't check it against historical results, but it looks about right.

Various Arguments

I can hear the Shillerites (and Hussman) crying out in indignation: average CAPE is 16.4, since 1871. Why don't I assume reversion to that level?

The answer is pretty simple: if you bought when CAPE hit that level back in 2009 this model calls for returns of 12.5%, and you would have received that, and a little better.

The doom and gloom crowd may accuse me of being overly optimistic, looking for 4% growth ad infinitum. Well since 1881 E10 has grown 4.4% annualized. You could do the math on Dr. Shiller's data, if you take the time.

Margins are going to collapse from historically high levels. I don't know about that, what I do know is that average margins since 2000, when applied to current revenues for the S&P 500, suggest normalized earnings of $80, the same as Shiller's E10. And this model assumes the companies in the index only earn at this normalized rate. Right now, TTM GAAP earnings for the index are in the area of $100.

My Investment Reaction

I've been selling off my S&P 500 Index holdings in small increments on up days. I had new siding and roofing applied to my house this year, which depleted cash reserves. A new car was another factor. Vacations with family and an expensive hobby added to the drain. So I am bringing cash reserves back up to where they should be, and forgoing expected returns of 6% to 6.5% to make that happen.

This still leaves me about 90% in equities. 6% is below the 9% investors have enjoyed over the past century or so. I'm pretty sure we'll get a chance to invest at more favorable rates, maybe some time in the future. But in the meantime those companies are making money, and since I own the companies I own their earnings. Plus there is the dividend income.

Disclosure: I am/we are long SPY.

Additional disclosure: I own Vanguard S&P 500 index funds.