Sunday, August 8, 2010 2 comments ++[ CLICK TO COMMENT ]++

Will you match the long-term historical market return?

Here's an interesting revelation, courtesy of Crestmont Research:

The long-term average return from the stock market is 9.75%. As the elder baby boomers are now beginning to retire, they will be relying upon their investments and pensions for income. The youngest boomers have less than two decades to compound their savings into a retirement payload. Many boomers young and old—so to speak—have a vested interest in stock market returns for a secure retirement. So, from 2010, what length of time is needed to assure the long-term average return?
What do you think the answer to that question is? How long would it take someone to generate a 9.75% annualized return going forward?

(Note that we are not talking about posting 9.75% in a particular year but, instead, generating that as an annualized return over a period of time. Also note that, like most discussions, this is nominal return. Crestmont Research is using Morningstar data, sourced from Ibbotson, that starts in 1926. The long-term return number may change slightly depending on the data you use; overall, it tends to be around 10%.)

Crestmont Research's answer may surprise some:
NEVER—investors from today will never achieve the long-term average return. Not in ten years, twenty years, fifty years, or the eighty-four years that represent the most recognized long-term average return.
I think a lot about long-term valuation but even I am surprised that we won't hit the historical average—even if we go as long as 80 years.

Do note that we talking about the market as a whole. This doesn't mean you won't post better returns. The returns of successful stockpickers is obviously independent of the market. Nevertheless, this issue is something to contemplate since the vast majority, including me, you, and most of the readers here, will fail as investors; we would do no better than post market returns in our lives. I know that sounds defeatist but the reality is that only a few will succeed in investing, just like how barely anyone succeeds as an entrepreneur or how only a few of us will make it to the NBA or NHL even if we had tried when we were younger. However, the discussed matter here impact those who are wealthier (and won't increase their net worth as easily) or those closer to retirement (and won't be increasing their portfolio.) Younger investors won't be impacted by what is discussed here since their portfolios will increase signficantly over time—they are inherently dollar-cost-averaging.

Crestmont Research comes to their conclusion after considering the three elements that drive returns: earnings growth, dividend yield, and valuation change (i.e. P/E expansion/compression.) Based on historical numbers, it is highly unlikely—almost impossible—for the market to post the historical return. As some of you may already realize, the big culprit is the high valuation (i.e. high P/E ratio.) This means that, not only are you likely to see P/E compression, but the starting dividend yield is very low compared to history (typically when valuations are high, dividend yield is low and vice versa.) If you are interested in this topic, I suggest that you read the article that was linked above.

So what does Crestmont Research expect the long-term return to be?

Well, the return will depend on what happens to the P/E ratio (valuation) since the other two (earnings growth and dividend yield) are more stable and predictable. Crestmont Research expects a best-case return of around 5%. It will be slightly lower if the P/E ratio compresses further (i.e. valuation over-shoots to the downside.)

The long-term nominal return is 9.75% and Crestmont Research expects P/E compression (P/E ratios are above long-term average) to contribute -1.31% relative to the average; earnings growth to contribute -1% (mostly because they expect inflation to be lower than in the past); and dividend yield (which is much lower than the long-term average) to contribute -2% relative to the long-term average. So you end up with around 5%.

What does all this mean? The results here don't apply to younger investors, stockpickers, foreign market investors, bond/commodity/real estate investors, and the like. The impact is on people closer to retirement or those who have most of their net worth invested and can't raise it (through their salaries.) We are basically talking about passive-type investors. People closer to retirement should lower their forward-looking return estimates. It is safer to assume it is going to be 5% than 10%.

My guess is that we will see a pension crisis and the bankruptcy of several insurance companies if long-term stock market returns end up being 5%. I'm not too knowledgeable about institutional investing but I get the feeling that many pension fund/insurance fund/endowment managers are promising benefits based on returns closer to 7% or 8%. They invest in assets other than US stocks, such as emerging market equities or corporate bonds, but I think those assets will post even lower returns.


2 Response to Will you match the long-term historical market return?

thiruppathy raja
August 9, 2010 at 12:38 AM

Thank you for the info. It sounds pretty user friendly. I guess I’ll pick one up for fun. Thank u.

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September 10, 2010 at 5:17 AM

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