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Why This Bull Market Is…Bull

A realistic expectation about future stock returns.

January 7, 2015

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bull“Despite the ‘fear factor’, bull market could last for decade” pronounced a recent article in the Globe and Mail. In it there was a projection by one of Bay Street pundits that, “the S&P 500 will return an average of 8 to 10 per cent per year” for the next decade.

I found this projection interesting and set out to examine how realistic it is, given what we know at this point in time, by decomposing total stock returns to its components, namely dividend yield, inflation, real earnings growth and change in the valuation multiple. I then examine the likely contribution of each one of these components to total stock returns going forward.

First is the dividend yield. Over the last 130 years, the dividend yield contributed 4.4% to annualized stock returns. That is, almost half of the total returns in the stock market over that period came from dividends according to Robert Shiller.

Between 2001 and 2014, however, only about 1.6% of total returns came from dividends. Given the documented preference by companies to buy back shares in recent years, the contribution from dividends going forward may be closer to the 2001-2014 experience than the average experience of the last 130 years.

Second is inflation. Historically, and over the period referred to above, inflation contributed 2.4% to annualized total stock returns. Given current bond and real return bond yields, the markets expect inflation in the future to be close to 2%.

Third is real earnings growth. Using the growth in Shiller’s 10-year average inflation-adjusted trailing earnings as a proxy, real earnings growth contributed 1.6% to total stock returns over the last 130 years.

Given the significant increase in share buy backs in recent years, which will probably continue in the future, it is quite likely that this component will contribute more to total returns going forward than its historical average. This is also borne out by the average contribution of this component to total returns since 2001, which was 2.2% — higher than the historical average.

As a result, real earnings growth may contribute a bit higher than 2.2% to total returns going forward, say 2.4%.

The last component of total returns is the change in the valuation multiple. The change in the valuation multiple, proxied by Shiller’s cyclically adjusted price-to-earnings ratio (CAPE), contributed 0.30% to total returns over the last 130 years.

CAPE currently stands at about 25 times vs. a historical average of about 16 times. To get a sense of the possible change in the level of CAPE going forward, and its potential contribution to total stock returns, one needs to understand the drivers of CAPE, which are interest rates and growth in earnings expectations. The higher the interest rate and the lower the earnings growth expectations, the lower CAPE is.

There are two facts to consider in this respect. First, corporate profits are booming because of declining commodity prices and a weak jobs market that has driven down the cost of labour (the share of U.S. GDP going to labour income is at its lowest level in 50 years). So one has to wonder where the growth in profits will come from, especially as going forward it is fair to assume that we will be in an environment of lower government spending, higher taxes and lower productivity.

Second, the current environment of rock bottom interest rates leads to the conclusion that there is an increased chance of higher interest rates in the future. The only positive factor in this respect is the flurry of share buy backs which will most likely continue in the future and will increase expected earnings per share growth, counterbalancing some of the impact from the adverse macro environment referred to above.

As a result, chances are that CAPE will decline going forward as we go to a period of higher interest rates, since there is not much scope for a meaningful increase in earnings growth expectations.

Let’s look at what happened to the change in the CAPE valuation multiple and its contribution to total returns in the 1960s, which was an environment of low interest rates to start with which moved higher over the decade. In the 1961-1970 period, the CAPE contracted and its contribution to total stock returns amounted to -1.1%.   I will use the same figure as the contribution of the valuation multiple change to total stock returns going forward.

The above projections of the total stock return components can now be summed up to arrive at a total stock return expectation of 4.9% (i.e., 1.6%+2%+2.4%-1.1%) going forward. This is considerably lower than the 8% to 10% stock returns that pundits are forecasting over the next decade and has significantly different asset allocation implications than those entailed by the 8%-10% projections.

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