The first ten years of the 21st century, the S&P 500 provided investors -1.9% average annual rate of return. In 2009, the stock market hit a low point in March and then climbed back impressively the rest of the year. Equity investors in the U.S. markets are a bit shell-shocked.
What return should investors expect from the U.S. stock market for the next ten years? Historically, a popular approach in determining what investors could expect long-term from the stock market was to average historic annual stock returns. Ibbotson Associates’ analysis of the annual returns for U.S. large capital stocks 1926-2009, found the stocks produced +11.2% average annual returns. In 1999, some of the most respected investors were expecting -3.5% to +6% average annual returns for the next decade. These prescient investors utilized some form of valuation, like the price/earnings ratio, to refine their expectations for the stock market. Investors expected return is important because it drives investors’ asset allocation decisions. The allocation decision has the biggest impact on investors’ portfolio returns.
By incorporating the price/earnings ratio level when one establishes their expectations for stock returns, investors increase their probability of having their expectations being closer to actual investment returns. Looking at the average annual returns for decades from 1950 through 2009, the average annual return for the S&P 500 was +11.0%. During this period, the average price/earnings ratio was 13.5. The three decades where the preceding year’s price/earnings ratio averaged 8.4, the S&P 500 produced an average annual return of +18.2%. For the three decades where the preceding year’s price/earnings ratios averaged 18.5, the S&P 500 produced a +4.2% average annual return. By taking into consideration the valuation of the stock market, via the price/earnings ratio, and investors would have reduced their investment in the stock market when it performed below average and increased their investment in the stock market when its valuation was below average. Thus, investors’ long-term returns would have been closer to actual results and their financial plan.With the S&P 500 at 1,090 on July 14, 2010 and trailing twelve months earnings at approximately $63.78, the price/earnings ratio is currently 17.1. This ratio is close to 17.7 price/earnings ratio for the S&P 500 in 1959, which was followed by a +3.3% average annual return for the 1960s. Market experts have been predicting lower stock returns for some time now. Jeremy Grantham, who estimated in 1999 that stocks would produce -3.5% average annual returns over the next ten years (actual return was -1.9 %), advised in his April 2010 letter to investors, that stocks could be expected to return approximately 2% annually over the next seven years. Warren Buffet back in 2001 expected stocks to return 6% after transaction cost for the next two decades. Roger Ibbotson, founder of Ibbotson Associates, in July 2009 article, Are Bonds Going to Outperform Stocks Over the Long Run? Not Likely, expects stock market returns over the next 40 years of around +7% per year. John Bogle, Founder of The Vanguard Group, in an interview by Morningstar, published on June 9, 2010, said, “it would be reasonable to expect 7% per-year returns for stocks over the next decade.” By incorporating, the price/earnings price level; history guides investors to expect +3.3% average annual returns for the next ten years. Some of the respected stock experts expect stocks’ return to range from +2% to +7% per year for the next decade. If anyone tells you that, that stocks should produce +11.2% average returns for stocks for the next ten years, slowly, stand up and walk away.