There's a certain amount of "behind the curtain" mystique accorded to the equity market analysts, fund managers, and market talking heads that constantly bombard us with information on various business news channels and on the pages of the leading news publications. What should you buy now? What's the hottest stock? What will future market returns look like? Where should I allocate in the US or around the globe? This fills a lot of space and does a heck of a job of pushing both institutional and individual investors in many different directions. I suppose we at IronHorse can be judged guilty considering we send out investment outlooks each month and write these blog posts. Frankly, judging future returns (not future volatility, but future returns, an important distinction) in just about any region can be pretty easy. Vanguard founder John Bogle nailed it in a speech last year to the NMS Investment Management Forum. Basically, you can become the prognosticator of the decade by using three simple numbers to come up with ten year annualized returns: expected nominal GDP growth, dividend yield at the beginning of the decade, and multiple expansion/contraction potential. Multiple expansion/contraction sounds confusing; actually the concept is pretty simple. Take a long-term P/E measure like the 10 year normalized P/E (a P/E ratio using the average of trailing 10 year earnings). Determine how far away P/E is from the historical mean percentage-wise and divide it by 10. Add the three numbers together and you get the expected annualized returns for a particular market. For instance, if you expect nominal GDP growth to be 5% per year, the starting dividend yield is 2.5%, and the market is 50% overvalued. You'd expect annual total returns over the ensuing decade to be approximately 2.5% per year (5 + 2.5 - 5).
Why should this work? Well, over time total stock market returns are derived from earnings growth, dividends, and animal spirits, or lack thereof. Over a long period of time, earnings growth should roughly track nominal GDP growth. It's not perfect, but it's pretty close. Since 1930, compound annual nominal GDP growth in the US, for instance, is approximately 6.5%. Using Robert Shiller's public database of earnings, compound annual earnings growth over that time is just south of 6%. The average dividend yield over that time period has been approximately 3.5%. Add 6.5% and 3.5%, and you get 10%. Compound annual total returns for the US markets since that time are approximately 9.8%. Again, it's not exact, but pretty darn close. Focusing in on specific time periods, we see there are times, like the late 1990s in the US, where investors get way ahead of themselves, the "animal spirits" go crazy, and market valuation multiples shoot through the roof. In 2000, the 10-year P/E was astoundingly around 40x. There are other times, like the early 1980s in the US, where investors want nothing to do with stocks; single digit earnings multiples reflected this. Reversion to the mean takes hold and provides either a headwind or a tailwind.
How did that work out last decade? Almost perfectly, in fact. Compound annual nominal GDP growth in the US was 4.1% between the end of 1999 and the end of 2009. The dividend yield at the beginning of the decade on the S&P 500 was 1.16%. The 10-year normalized (trailing 10 year average earnings) P/E was 62% overvalued (43.7x vs. a long term average of approximately 16.5x). Add the numbers together, 4.1 + 1.16 - 6.2, and you get a compound annual number of -0.94%. What was the actual number for annual total returns over the past decade? -0.4% per year. Very, very close. The point isn't to hit the number exactly. The point is to understand whether conditions are favorable going forward, or unfavorable. If one's GDP forecast were a percentage or two higher than the numbers that actually arrived, the investor still faced a pretty discouraging decade ahead. The multiple contraction headwinds going into the 2000s would have been incredibly hard to overcome no matter the overall economic conditions. Animal spirits broke out in a big way during the 1990s and investors paid the price during the ensuing decade.
So where do we stand now? What does the next 10 years look like? In the US, the current dividend yield is approximately 2.5%. Let's say this decade economically will mirror last decade in terms of subaverage annual nominal GDP growth of 4%. The current market multiple is 22x, or approximately 25% above the historical mean. 2.5% + 4% -2.5% = approximately 4% per annum nominal total returns over the next decade. Put on your optimism hat and add 2.5 percentage points of nominal GDP growth per year, and the US forecast would come in at 6.5%, about 3% per annum short of the long term average. Such is the nature of potential multiple contraction headwinds. On the other hand, apply the analysis to emerging markets, which are currently trading at approximately 13.5x, or approximately 22% below what we'll consider a viable long-term average. Let's be really conservative and accept that nominal GDP growth in emerging markets slows to a crawl relative to the recent past. In this case, let's peg them with 5% annual nominal GDP growth, not much above the US. The dividend yield in emerging markets is approximately 2% right now. Add 5% + 2% + 2.2%, and you get 9.2% per annum. Even under very conservative assumptions, an investor is looking at potential double digit returns in emerging market equities. Last but not least, apply the analysis to global, ex-US, EAFE markets. Nominal GDP growth should remain constrained, maybe around the 3% level (implies real GDP growth somewhere around zero). The dividend yield is around 3.5%. Valuations are roughly in line with historical mean. 3% + 3.5% + 0 = 6.5%. total annualized return, in line with the optimistic US scenario.
What's the back of the envelope story? First, understanding and estimating future returns doesn't require a ton of computing power. And, global stocks seem to provide more promise over the next decade or so than US stocks. We'll see what happens!
