Another theory of predicting future stock market returns states that there are three main components to long-term stock market performance. Amongst many others, I learned this from authors and investors Jack Bogle and William Bernstein.

Part 1: Dividend Yield
If your stock distributes 2% in dividends each year, then you will have a 2% contribution towards of return. This is what dividend investors love to see coming in each quarter, and is relatively easy to track for a large group of companies. Here it is over time for the S&P 500, courtesy of Multpl.com:

Part 2: Earnings Growth
If earnings stay constant, then all other things equal, one would expect the share price of your company to stay constant as well. If the earnings grow by 5% every year, then your share price will grow by 5% per year. Thus, earnings growth rate is a vital component of total return.

If your portfolio was all of the stocks traded in the United States, like that of a broad-based index fund, this would create a connection between the growth rate of the nation’s Gross Domestic Product and the earnings growth rates of all US companies. In other words, the fundamental return is based on GDP growth. In turn, the GDP growth rate is connected to population growth and productivity per person.

These two parts added to together are coined the fundamental return:

Some bad news: Now, from 1950-2000, fundamental returns were 10%: 4% dividend yield and a 6% earnings growth rate. These days, the S&P 500 has a dividend yield of only about 2%. Earnings growth rate estimates are subject to debate, but they hover around 5-6%.

Part 3: Changes in P/E Ratio
The price-to-earnings (P/E) ratio is the price per share divided by earnings per share. In other words, it is how much investors are willing to pay for each unit of earnings. If they are willing to pay 20 times annual earnings, the share price of the stock will be twice as high as if they only paid 10 times earnings. This part is denoted the speculative return, as it has changed throughout history. Here it is again for the S&P 500:

In 1950, the P/E ratio was less than 10. As of right now in mid-2010, it is 20. It is very unlikely that this more than doubling of price-per-share will happen again, with the historical average being around 15. (During the dot-com bubble, the P/E ratio was over 40. In 2008, it was over 25.) This will lead to a zero, and quite possible negative, future speculative return!

Summary

Source: Little Book of Common Sense Investing, Exhibit 7.1

When predicting future returns, you have to look at all the sources of those expected returns. Fundamental return is still a solid reason why stock prices will go up on the long-term, especially if you are not investing only in one country or economy. Some people call it a belief in capitalism, that economic growth will continue and GDP will continue to increase. I simply believe in the passion and motivation of all the people out there, from Sweden to China to Brazil. However, there is good evidence that you might not be getting 10% historical returns due to P/E ratio contraction.

In a recent column, Larry Swedroe shares that the forecasts that he has read are predicting a 5% total annual growth in earnings and 2% dividends for a total return of 7% (similar to above). Inflation is predicted at 2.5%. However, he points out the current minimal-risk return is pretty low as well, so you need consider the big picture:

The bottom line is that while the expected nominal return to stocks is lower than the historical return, so is the expected return to Treasury bonds. You should decide if the expected risk premium for stocks is sufficient given your unique ability, willingness and need to take risk.

Every year, the low-fee investment advisor Portfolio Solutions, LLC founded by Rick Ferri provides a 30-year market forecast based on their analysis of several factors. In their own words:

Each year, we analyzed the primary drivers of asset class long-term returns including risk as measured by implied volatility, expected earnings growth based on expected long-term GDP, market implied inflation based on the spread between long-term Treasury Bonds and TIPS, and current cash payouts from interest and dividends on bond and stock indexes. These factors plus others are used in a valuation model to create an estimate for risk premiums over the next 30 years. In a sense, we believe these expected returns reflect what the market is estimating will be a fair payment for each asset class over T-bills over the long-term.

You can view all the asset classes on their site, but I have included some of the major ones below for preservation and reference. Another set of estimates to throw into the mix.

*The estimate of risk is the estimated standard deviation of annual returns.

As part of gathering the data needed to go beyond net worth, I’ve shown ways to track find your personal savings rate by tracking your current spending with your current after-tax income. For now, I’m skipping ahead to estimating your portfolio’s long-term investment returns.

There are a lot of ways to estimate future stock returns. You’ve probably heard of the P/E ratio, which is usually the price divided by last year’s earnings. This is one measure of “value”. Here is a plot of historical values of the inflation-adjusted S&P 500 index, along with its annual earnings (source).

Historical Price & Earnings Separately

Historical P/E Ratio

As you can see, there is a lot of volatility in P/E ratio. The “P/E 10” ratio is the share price divided by the average earnings over the last 10 years. By taking a long-term average, you smooth out the noise and bumps.

Professor Robert Shiller of Yale University, which provided the above data as well, spoke about the usefulness of this ratio in his book Irrational Exuberance, and provided the data for the following chart. The x-axis shows the real “P/E 10” of the S&P Composite Stock Price Index (inflation adjusted price divided by the prior 10-year mean of inflation-adjusted earnings). The y-axis shows the geometric average real annual return of the same index, reinvesting dividends, and selling 20 years later.

Price-Earnings Ratios as a Predictor of Twenty-Year Returns

You can definitely see the relationship that a higher P/E10 usually leads to a lower future return. However, there is still a great deal of scatter for any given P/E10 ratio.

What about today? As of June 2, 2010 the P/E10 is 19.99 with the S&P 500 index at around 1,098. Historical average is about 15. Back in March 2009 when everything was looking bleak, the P/E10 was 13.32. (P/E10 is also referred to as Cyclically Adjusted Price Earnings (CAPE) ratio.)

The Early Retirement Planning Insights website provides a calculator that forecasts future returns based on the current value of P/E 10, again using historical returns. I’m not sure exactly how they did all the regression. Here’s their return forecast for a P/E 10 ratio of 20.

Future Returns Prediction (P/E10 = 20)

For a 20-year forecast, it shows an average outlook of 4% returns, on a real (after-inflation) basis. Of course, the range indicates that the actual returns could look much worse. As the time-horizon lengthens, the range gets smaller due to the phenomenon of reversion to the mean. Kind of scary to look 60 years ahead!

Warnings

To me, this stuff is useful as a general Big Picture planning tool, not as a short-term trading tool. These are just predictions based on the past, which is often the best we can do, but still far from perfect. Many people use P/E10 as a tool for market timing, shifting their asset allocation as it rises and falls. Shiller himself states that his plot above:

confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low.

That may be true, but market timing systems can really test an investor’s faith when they seem to be wrong for a long period of time. On a personal basis, I’d probably limit any asset allocation moves – if any – to if the P/E10 ratio moved to an extreme, for example dropped below 10 or above 25.

The U.S. government tracks inflation in many ways, and one popular way is the Consumer Price Index (CPI). This index is then used to adjust everything from income tax brackets to Roth IRA contributions limits to pension payouts to the return on inflation-linked bonds (TIPS). There are then sub-indices for different groups and regions.

Each month, the Bureau of Labor Statistics gathers 84,000 prices in about 200 categories — like gasoline, bananas, dresses and garbage collection — to form the Consumer Price Index, one measure of inflation. […] The categories are weighted according to an estimate of what the average American spends, as shown below.

The NY Times put together a nice interactive infographic that helps explain the ingredients of the CPI and their relative importance:

You can hover your mouse, and zoom in/out as you like. Does it match your personal spending and inflation rates? Probably not, so it’s good to note the differences. For instance, actual housing prices are not included in the CPI, but instead “owner’s equivalent rent” (24% of CPI) is tracked which is defined as what homeowner’s would pay to rent their home. And once I get my mortgage paid off, I’ll be more worried about other things like health insurance (only 6% of CPI).

Link via the Betterment Blog (Betterment review upcoming).

I received a thought-provoking comment last week on my Fidelity Portfolio Advisory Service review. Since this post is a couple months old by now, I doubt most readers saw it. After reading it, my first guess was that somehow the visitor was interested about Fidelity PAS and also read up about my own investing activities.

Even thought the comment wasn’t blatantly baised, on a gut instinct, I checked the IP. As I suspected, the visitor came from a Fidelity Investments internet domain. Still, that doesn’t mean the person is necessarily wrong, just most likely works for Fidelity. 🙂

Anyhow, the comment from “Ryan”:

I would ask yourself why you were “stuck” in cash and missed the market rally. Was it because you were emotionally involved? Trying to time the market and got in/out at the wrong time? Where you frozen to the point where you didn’t know what to do? Those kind of mistakes can REALLY hurt a portfolio’s return in the long run. I would say if you are ready to commit to a discipled strategy and stick to your asset allocation & rebalancing plan, you are ready to manage the portfolio on your own. You can also think about taking 10% of your portfolio to invest in individual stocks to see if you can get lucky with a few and boost your overall return. But you also have to be prepared to do your homework (jim cramer says an hour a week per stock, so thats 10 hr/week) on those stocks. If you are honest with yourself and don’t think you will have the time, expertise, or interest to keep up with the management of your portfolio, best to have someone do it for you whether it be through actively managed funds or professional management.

I both agree and disagree with parts of this comment.

Yes, I agree that it is one thing to set up and asset allocation and re-balancing plan, and it is another to execute it in times of uncertainty and market turmoil. This is your family’s future. Right now, with the S&P 500 at 1200, it would be good to look back over the last couple of years and see if you kept your stock/bond ratio at your desired targets when the markets were doing much worse. We you unsure? Scared to pull the trigger? Wanted the economy to get “just a bit better” before jumping back in?

However, I don’t agree that if you did have problems, the solution is “actively managed funds or professional management”. Well, not exactly. Why not go back to something simple and low-cost, like the Vanguard Target Retirement Funds? You will receive the power of passive investment into thousands of companies representing every industry around the world. You’ll also be invested in high-quality investment grade bonds from the US government, US agencies, and strong corporations. And you don’t have to worry about rebalancing, because they will do it for you. All at a rock bottom price of about 0.20% of assets annually ($20 a year for every $10,000 invested).

Take VTIVX, the fund for folks retiring around 2045. Want an IRA? Set up automatic investments into VTIVX. Got more to spare from the paycheck? Set up a automatic investment in a taxable account? Got a bonus? Throw it into VTIVX or similar. Scared? Just sit tight, VTIVX will rebalance for you. Don’t sell. Don’t buy anything else. Inaction is actually in this case. No, it won’t be perfect, but it will be a lot better that most of the other options out there. If you had trouble recently, perhaps it’s time to go back to simplicity?

In any case, there is no way I’d pay 1.74% in annual fees to Fidelity to manage my portfolio. Such crazy-high fees can also REALLY hurt a portfolios return, like facing a 50 mph headwind. I’d choose a Vanguard Target Retirement fund of comparable allocation over a 15+ year period vs. any Fidelity PAS portfolio any day of the week and twice on Sunday.