As promised in my June 2012 column on bond returns [“What Did You Expect?” Wealth Wise], I now turn to the subject of expected returns from stocks.
How many times have you heard that stocks have generated an average 10 percent annual return over the past 50 or 60 years? While basically true, this historical data has little bearing on how stocks are likely to perform over the next five, 10 or even 50 years.
PIMCO, the well-known Newport Beach bond manager, has just published a paper by Saumil Parikh, titled “Forecasting Equity Returns in the New Normal.” His conclusions will not help some advisers sleep well at night.
Before looking at Parikh’s arguments, let’s remember the difference between “nominal” and “real” returns. The former is the number you calculate using beginning and ending balances and factoring in the time period. “Real” returns begin with nominal returns, then subtract out inflation. Since the end of World War II, stocks have generated approximately 10 percent annual returns (nominal) in an environment of inflation that varied widely but averaged about 3.7 percent per year. Subtracting the rate of inflation from the nominal returns gives us about 6.3 percent for the annualized real returns. Real returns, or the returns you can spend without your capital being eroded in value by inflation, are almost always lower than nominal returns.
Now let’s look at the Parikh article. He identifies three primary sources that drive equity returns: returns from income (cash delivered to shareholders through dividends and stock buybacks); returns from growth of the economy and the firms operating within the economy; and returns driven by changes in valuation.
Let’s look at the last of these first. “Valuation” can be most easily understood as the relationship between the price of a share of stock and the company earnings (profits) attributable to that share. Over time, the ratio of price to earnings of the overall market changes—sometimes higher, sometimes lower. PIMCO expects the current ratio of about 21 to decline to about 17 over the next five to 10 years. If it’s correct, this would mean a -2.1 percent annual drag on returns if this occurs over 10 years, to as much as -4.1 percent annually if this occurs over five years. If we assume no change in price/earnings ratios, this factor will have no impact on our estimate of future returns.
As for income returns from stocks, PIMCO forecasts these to average about 3.7 percent over the next five to 10 years. This is pretty much in line with recent trends, so it doesn’t look for much change here.
Where PIMCO does see significant change is in returns from growth. It divides this factor into two major components: growth in Gross Domestic Product (GDP) and changes in the share of GDP accounted for by corporate profits. In recent years, the share of GDP reflected in corporate profits has been high and rising. However, without significant GDP growth, PIMCO believes our unsustainable public sector deficits will put tremendous downward pressure on the ability of corporate profit growth to match the growth in GDP.
Since 1900, the United States has experienced an annualized nominal growth in GDP of 6.4 percent. By PIMCOs estimation, that rate is likely to slow to between 4 percent and 5 percent over the next decade, and the share of corporate profits is likely to decline. Thus, both the slowing growth in GDP and the declining percentage of that growth reflected in corporate profits will have a significant dampening effect on the expected growth returns from stocks.
And now for the bottom line: Following PIMCO’s analysis, we can expect, as Parikh puts it, “the broad U.S. equity markets to produce nominal, annualized total returns in the +4.0 percent to +5.1 range over the next five to 10 years. These returns are far below the S&P 500 historical long-term returns of nearly 10 percent, but better than the past decade of total returns delivering just over 2 percent annually, compounded.”
What does that mean for those in retirement expecting to live off dividends and interest on their investments? To find out, we convert Parikh’s nominal stock returns to real returns in the same way we did our expected bond returns, that is, by subtracting the anticipated rate of inflation. We could subtract the historical inflation rate of 3.7 percent, but let’s be more generous and use the expected rate of inflation derived by looking at the difference in yields between U.S. Treasury bonds with fixed yields and those whose yields are adjusted for inflation (called “TIPS”). Today, that difference is about 2.5 percent.
Using the upper range of PIMCO’s estimate for stocks, we’re looking then at an expected real return from stocks of about 2.5 percent. If we assume a balanced portfolio pairing equal amounts of a broad equity index fund and a broad market bond fund, whose current expected real return is about -1.5 percent, we’re looking at an expected portfolio real return of barely 1 percent. Another way of putting it is that one should draw only $10,000 annually out of a $1 million portfolio if one wishes to preserve the purchasing power of that portfolio indefinitely.
Is it any wonder advisers are having a hard time sleeping?
This column is not intended as investment advice. You should consult your own adviser in determining whether to incorporate any of the opinions expressed here in your investment decisions.
