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Stocks: Why You Can Still Bank
On an 8% Return

Investors shun stocks at their peril. Attractive returns are in the cards.

By Richard DeKaser, Contributing Economist, The Kiplinger Letter

April 26, 2010

Soured on stocks? It’s understandable that many investors have, after watching their assets founder for so long. If you invested $100 in the Standard & Poor’s 500 in April of 2000, you have only about $97 today. That figure, which includes reinvested dividends, amounts to an annualized return of -0.3%. Ouch! Since 1926, annual returns have averaged nearly 10%.

Many investors now question whether expecting those kinds of gains is realistic anymore. But avoiding equities would be a mistake. Stocks still present an attractive investment, despite the past decade’s historically dismal showing, and even after the past year’s spectacular 70% gain. You might think that the time to buy has passed. After all, it stings to pay $100 for something that traded at $59 just 12 months ago. But investing based on the recent past is like driving a car while focused on the rearview mirror: stupid and dangerous.

Looking ahead, annual returns of 7% or so is likely in the coming decades ... and perhaps 8% to 9% over the next 10 years or so.

To understand why, start by considering what kind of profit growth can realistically be expected, since common equity is ultimately a claim on a company’s earnings. For any given company, answering the question is daunting. Aside from revenue prospects, financial condition, the competitive landscape, the cost outlook and management competence must all be considered. But for the market as a whole, the calculus is simpler: Profits grow about as fast as the economy overall.

Since 1947, corporate profits have averaged 9.4% of gross domestic product, narrowly ranging between a high of 12.1% (1950) and a low of 6.3% (1982). Moreover, the growth rates for profits and GDP hang tight. Over that time span, GDP has grown 8% a year on average, while profits increased 7.9%. During the past decade, corporate profits and GDP each increased at exactly a 4.3% annual rate.

This past decade, of course, wasn’t an especially good 10-year span. It started at the pinnacle of the 1990s expansion and ended in the depths of the Great Recession. Going forward, an average of 5% annual economic growth is more likely -- with inflation of 2.25% and real growth of about 2.75%.

Next we need to factor in dividends. Over the past 50 years, the dividend yield for the S&P 500 averaged 3.1%, ranging from a high of 5.7% (1982) to a low of 1.1% (2000). Let’s conservatively assume a 2% dividend yield. With a trend of 5% earnings growth, that boosts the expected total return on stocks to 7% over the long run.

But as an economist once famously quipped, “In the long run, we’re all dead.” Time horizons measured in decades may make sense for the youngest among us, but mature investors aren’t quite so patient. So let’s assume a 10-year investment horizon -- long enough to abstract from unforeseeable events, but short enough to be relevant for musing about retirement. In this case, valuation must be considered as well as earnings and dividends. Naturally, an overvalued market will tend to underperform the long-term trend and an undervalued market will tend to outperform it. So: Is today’s market overvalued or undervalued?

The standard tool for judging valuation is the price-to-earnings multiple, essentially a measurement of what investors are willing to pay for each dollar of corporate earnings. And since investors shouldn’t be looking in the rearview mirror, it’s expected future earnings that matter most. With the S&P 500 index now hovering around 1200, and analysts predicting $78 in operating earnings over the next year, that translates into a price-to-earnings multiple of roughly 15. That’s strikes me as cheap, especially since the average multiple since 1988 is 19. Even excluding the frothy years of 1998 though 2000, the average multiple is 18. A gradual expansion of the P/E ratio to 18 over the next decade means the total return to stocks will be even higher than the 7% long-term average. So,at least for the coming decade, an average annual total return 8% to 9% is a fair bet.

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