US stock prices have made little headway in more than thirteen years, and the cumulative real returns generated by the major market averages have lagged Treasury bonds by a substantial margin over the period. The uber-bulls are confident however, that the more than decade-long stagnation has led to attractive valuations that should pave the way for strong returns in the years ahead, and some investment practitioners have gone as far as to predict a doubling in equity values by 2022. Is the optimism justified?
It is important to appreciate the sources of historical real stock market returns, which can be decomposed into three building blocks – the dividend yield, real growth in earnings-per-share, and changes in valuation. Since 1871, US stocks have delivered annualised real returns of 6.5 per cent, of which more than seventy per cent is attributable to the dividend yield, roughly one quarter to real growth in earnings-per-share, and the remainder to an increase in the valuation multiple attached to current per share profits.
Looking forward, future returns seem virtually certain to fall short of the historical experience, simply because the dividend yield is little more than two per cent today or less than half its long-term mean. The uber-bulls will undoubtedly argue that the dividend yield understates the total payout to shareholders, due to sizable increase in share repurchase activity in recent decades.
However, share buybacks are already included in per share numbers, and adjusting the payout ratio upwards would be double-counting. In other words, an existing shareholder can either participate in the buyback and miss out on the earnings-per-share accretion, or forego the cash distribution and benefit from the capital gain. Thus, forecasting future returns on a per-share requires no adjustment to the dividend yield.
The second building block in estimating future returns is the real growth in earnings-per-share, which is linked to the economy’s long-term growth rate. However, existing shareholders have a claim on publicly-quoted per share earnings and not economy-wide profits.
Initial public offerings and secondary issues account for a considerable portion of the growth in aggregate earnings through time, and as a result, the growth in per share numbers falls well short of the cumulative increase in total profits. Indeed, real earnings-per-share have increased at an annual rate of just 1.7 per cent since 1871, or roughly half the pace of economic growth.
The optimists put forward a variety of reasons as to why earnings-per-share growth will be higher in the future, but none stands up to serious scrutiny. It is argued that share repurchases will provide a boost to earnings, which conveniently ignores the fact that the reduction in share count through time is largely a myth. Indeed, new share issuance in excess of buybacks has averaged 1.25 per cent a year over the past half century, and repurchases have exceeded new issuance in just eight years.
The second argument relates to the growing share of profits generated overseas in high-growth markets. The share of revenues sourced in foreign markets has increased from about thirty per cent more than a decade ago to almost fifty per cent today. However, roughly sixty per cent of overseas revenues come from mature European economies, with a further ten per cent coming from Canada. All told, just one in every eight sales dollars is generated in high-growth economies, which is simply not large enough to provide a meaningful boost to earnings growth.
The bulls also fail to appreciate that globalisation is a two-way process, and just as American multinationals have made impressive share gains in overseas markets, the same is true of foreign companies in the US. Indeed, foreign subsidiaries have captured an increasing slice of economy-wide profits over the past two decades, with the share rising from just five per cent in the early-1990s to about fifteen per cent today.
Finally, the global financial crisis and the calamitous drop in economic activity have had a lasting impact on corporate sector behaviour with elevated unemployment levels and a relatively low business investment rate threatening to lower potential future growth rates in the developed world. All told, there is no reason to believe that long-term growth in real earnings-per-share will stray too far from its historical trend.
The final input to the return estimation process is valuation change. The market looks reasonable value on current earnings, but the greater than twenty multiple on cycle-adjusted profits is closer to previous secular bull market peaks than bargain basement levels seen in the past.
The bulls argue that the multiple is inflated due to the collapse in corporate profitability during the crisis, but using median earnings over the past decade or a denominator based on twenty-year average earnings to correct for the recession does not paint a different picture; the stock market is expensive.
The best the bulls can really hope for is no change in valuation multiples, which could prevail if macroeconomic volatility drops from its currently elevated levels. However, should macroeconomic volatility remain high, it is far more likely that valuation multiples will contract, and at the very least, return to their historical mean.
Careful analysis suggests that equity investors can reasonably expect annual real stock market returns of 3.5 to 4 per cent at best in the decade ahead – well below the historical experience, and could deliver far worse should valuation multiples contract. The bullish optimism is unfounded.