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Robert Powell's Your Portfolio
March 24, 2011, 12:01 a.m. EDT
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By Robert Powell, MarketWatch
BOSTON (MarketWatch) "” There's a good chance the stock market will return 6.5% over the coming decade, after inflation, according to a new study. It's not as though that's money in the bank, but the findings can serve as a useful reality check for those trying to predict a rate of return for the equity portion of their portfolios over the next 10 years.
For the record, that 6.5% is the historical average of stocks since 1875, according to researchers at the Boston College Center for Retirement Research (CRR). And even though 6.5% might seem a meager return, it might prove to be a welcome relief to the roller coaster ride of the past two decades in which stocks gained, on average, a chart-topping 14.5% from 1991 to 2000 and then proceeded to lose on average 1.1% percent from 2001 to 2010.
In coming to their forecast, the authors of the paper, Richard Kopcke, a senior economist at the CRR, and Zhenya Karamcheva, a research associate for the CRR, noted first and foremost that long-run real return on stocks is the sum of two components, the dividend yield and the real (as in adjusted for inflation) rate of appreciation.
(Investors, as we know, are fond of saying that small stocks have gained on average 12% per year since 1925 and that large stocks have gained on average 10% over the same time period. And that's true, but those returns are not adjusted for inflation.)
So what's the logic behind Kopcke's and Karamcheva's forecast?
Well, the first thing they note is that most forecasters expect subpar returns from stocks over much of the coming decade as the economy recovers slowly from the recent recession. They point out that stocks in recent years have paid shareholders lean dividends, and now the sluggish recovery will limit the growth of corporations' earnings and stock prices.
Kopcke and Karamcheva, however, say there is a broader way of viewing the prospect for equities. They suggest that the return on stocks will depend on corporations' profitability. "Companies' earnings have recovered strongly since the recent recession, and the valuation of those earnings reflected in current stock prices is near its historical average," the authors wrote. "If companies maintain their profitability, stocks are likely to pay returns that match their historical averages over the coming decade, even if the recovery of the economy is weaker than average."
In their paper, the authors first noted capital gains have displaced dividends as the most important component of the return on stocks. "From 1951 to 1994, the average annual dividend yield of 4.6% represented just over one-half of the average real return on stocks. Since then, however, the composition of real returns has shifted away from dividends toward capital gains. From 1995 to 2010, the average real rate of appreciation of 3.8% represented 70% of the real return on stocks."
And that shift away from dividends toward capital gains can be attributed to two factors, they wrote. One, corporations paid a smaller share of their earnings as dividends after the 1960s; and two, stock prices were uncommonly high relative to corporations' earnings and dividends for much of the time between 1994 and the present.
All this by way of saying that "many investors now look to capital gains to assess the future returns on stocks, and they look to economic growth "” companies' ability to expand and increase their earnings "” to forecast capital gains."
The authors also wrote the appreciation of stocks is not necessarily anchored to the expansion of economic activity. "Corporations can increase the assets backing each share of their stock without installing new plant and equipment by using their earnings to purchase equity in other companies, to buy their own stock, or to retire debt," they said.
And so, even if the "the growth of GDP remains relatively low for much of the coming decade, corporations can use stock purchases as they have over the past 25 years to boost the growth of their stock prices to match past rates of appreciation."
In building their case for their forecast, the authors also said corporations do not need to produce relatively high rates of appreciation to offer their shareholders a high rate of return, just as they don't require strong economic growth to engineer relatively high rates of appreciation of their stocks.
What matters to investors, they said, is the magnitude of earnings. "Whether a corporation pays its earnings directly to shareholders as dividends or indirectly as additional assets per share of its stock, its earnings determine the total yield that it can pay its shareholders," the wrote. "The earnings yield "” earnings divided by the value of stock "” is an important gauge of the potential return on stocks."
So, when stock prices range around 15 times earnings, stocks offer an earnings yield near 6.5%, which is equal to the reciprocal of the price-earnings ratio of 15, said the authors of the paper. "If corporations can maintain their return on assets and investors remain willing to purchase stocks at prices near 15 times earnings, the real return on stock will match its earnings yield of 6.5%, which in this instance is very near the long-run average real return on stocks."
So where are we now? Stock prices are currently near 15 times earnings for the Standard & Poor's 500 index /quotes/comstock/21z!i1:in\x (SPX 1,298, +3.77, +0.29%) , said Kopcke and Karamcheva. And these prices offer investors an earnings yield that matches the long-run average real return on equity, or 6.5%. "Shareholders will tend to realize this return in coming years, provided corporations can maintain their earnings and stock prices do not drop and remain substantially below 15 times earnings," they wrote.
And one can make a case that the prospect for earnings is promising. The authors said earnings per share have recovered from the late 2008, early 2009 levels, rising nearly back to the peak values in 2007. More importantly, the authors said, corporations' profit margins "” profits after taxes relative to output "” have recovered strongly as well. Since the 1960s, profit margins ranged between 4% and 10% of output for nonfinancial corporations, and are now close 8.5% which is close to the level hit during the economic expansion of the late 1900s and the mid-2000s.
And so, the "continuing economic expansion not only would support earnings, but it also would encourage investors to take a more optimistic and confident view of future earnings," they wrote.
Robert Powell is editor of Retirement Weekly, published by MarketWatch. Learn more about Retirement Weekly here.Follow his tweets here.
Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.
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