Get Ready for Post-COVID

BY SCOTT NEAL

You’ve probably heard it said that the U.S. stock market average annual total return is about 10%. That’s widely publicized, so we wouldn’t fault you for holding that as your expected return. In days gone by, we even put the Ibbotson chart up on our wall that showed the value of stocks, bonds, bills and inflation over time since 1926. You can do an internet search and still find the chart that is conveniently updated each year (it still shows the long run average at around 10%).

We know that our readership can do arithmetic, so you can easily imagine how long it will take to move that very long-standing average away from the mean. You are likely to hear 10% being touted as the expected return of stocks for a long time. You also know, probably from experience, that the distribution of annual returns from stocks is rather wide. So, the big question: is it reasonable to use a projection of 10% on stocks for your financial plan or to set your expectations? Mostly likely it is not. Let’s explore why and delve into what to do about that.

First, let’s make sure that we know what makes up total return. Total return is equal to capital gains plus dividend yield. We can further break down capital gains into earnings per share growth times the change in the P/E (price earnings). When someone offers you a forecast of the market, you should be interested to know their assumptions for earnings growth, dividend yield, and changes to P/E if you want to test their forecast for reasonableness.

It’s very important to note that the 10% average return is for a very long and specific period: 1926 – present. It began at a time when P/Es were fairly low (those have doubled since then), and average inflation of 2.9%. Your personal time horizon is very important to the success of your financial plan.

It is not likely that your time horizon for planning is anywhere near 95 years. More than likely, your planning horizon is somewhere between five and twenty years. So perhaps it would be instructive to break down the components even further and determine some direction, if not the magnitude of change in the stock market.

According to author Ed Easterling of Crestmont Research, fundamental principles, not randomness, drive each of the three components. Earnings per share (EPS) growth is inextricably linked to economic growth (GDP). That makes sense since GDP is the total of all sales of goods and services, and earnings emanate from sales. P/E expansion and contraction are closely correlated to the inflation rate, and the starting point of the P/E ratio drives dividend yield. Periods starting with relatively high P/Es have low dividend yields.

For comparison, at the time of this writing (mid-August 2021) the current P/E ratio of the S&P 500 is estimated from the latest reported earnings and the current price of the index. It is about 35. The long run average is about 16. The Shiller CAPE (Cyclically Adjusted PE Ratio) is another common valuation metric and is based on average inflation-adjusted earnings from the previous 10 years. It stands at 38.5 as of this writing. We like to test this against other measures of