Expected Return Analysis for Equities
By Mark F. Toledo, CFANovember 27, 2018
Expected Return Analysis for Equities
Estimating the long-term expected return for common stocks requires both quantitative tools and qualitative judgments. John Bogle described a useful method for this estimate 26 years ago in an article published in the Journal of Portfolio Management in 1991. This method identifies three sources of return for common stock investors: dividend yield, earnings growth and change in the price earnings (P/E) ratio.
Our adaptation of this model leads to a current expected return of 9.4% for the S&P 500 over the next decade. This current estimate is 3.3% below the model’s the 10-year expected return of 12.7% as of December 2008. The lower long-term outlook results from the near 135% rise in the S&P 500 price index over the past eight years. Investors often overlook the reality that expectations for future returns fall as prices rise.
Corporate Profits
The dashed line in Chart 1 shows the volatility of S&P 500 operating earnings over the past 30 years. During the early 2000’s recession, earnings fell 32% from $57 in September 2000 to $39 in December 2001. Operating earnings subsequently more than doubled to $89 per share in mid-2007. In the 2008 recession, earnings fell 56% from $89 in September 2007 to $40 in September 2009. Since then, earnings rose modestly above the trend line in early 2011 and then fell below in 2015.
The volatility of earnings shown in Chart 1 suggests that a smoothing process may provide a better foundation for valuation analysis. We “normalize” earnings by computing a least squares regression line (central value) for profits. The central value line represents smoothed earnings to show a constant growth rate. The solid line in Chart 1 shows this measure of normalized operating earnings (NE), which provides the earnings for our valuation analysis.
Price Earnings Ratios
The solid line in Chart 2 shows the price to trailing 12-months operating earnings (P/E) ratio for the S&P 500. The dashed line shows the price to normalized earnings (P/NE), which is computed by dividing the S&P 500 December 2015 average price of 2,091 by normalized earnings of $120. At the end of December, these price to earnings ratio were 19.7 for operating earnings and 17.4 for normalized earnings.
These ratios diverged dramatically during the 2008-09 bear market and recession. The solid line shows a near average price to earnings ratio of 18.6 and deeply depressed price to normalized earnings of 10.3 in February 2009. By September of 2009, the difference widened to between a very elevated 26 times depressed operating earnings and a subdued 13 times normalized operating earnings.
From a valuation perspective, was the market expensive or cheap in 2009? We believe that smoothing earnings to evaluate the price to normalized earnings provides a better answer to this question. As a result, our analysis suggested that the market was very attractive from a valuation perspective in early 2009. Currently, the price to normalized earnings ratio is modestly below the last 30 year average, suggesting a modestly attractive valuation level.
Expected Equity Returns
To estimate the expected return for equities over the next ten years, we minimize the number of subjective judgments by using current data and relying on regressions to long-term means. The estimate begins with the current dividend yield of 2.1%. We then add the past 30-year annualized growth rate for earnings of 6.7%. Finally, we compute the annualized contribution to the return resulting from the price to normalized earnings ratio (P/NE) returning to its long-term average over the next ten years. As of December 2015, the change in P/NE from the current 17.4 to the 30-year average of 18.4 by December 2025 contributes 0.6% per year to the expected return. The combination of these components produces the current expected return of 9.4% for the S&P 500 over the next decade.
Chart 3 provides a graph of the actual (solid) verses expected (dashed) equity returns. The actual results represent the 10-year annualized return over the previous decade. For example, the plot for the solid line of -1.5% in December 2008 means that an investor, who bought the S&P in December 1998, would have earned a -1.5% annualized return over the ensuing decade (December 1998 to December 2008). At the other extreme, investors earned a 19.0% annualized return from December 1988 to December 1998 as shown by the plot point of the solid line for December 1998.
A visual inspection of Chart 3 shows that the expected return (dashed line) was well above the actual return (solid line) in the mid-1970s. For example, an investor who bought the S&P 500 in December 1964 realized a return of near zero over the next decade versus the expected annual return of 5.7%. The primary reason for this under-performance was that the P/NE contracted more than anticipated from near 20 in December 1964 to 8 in December 1974.
In contrast, the model under-estimated returns for investors who bought in the late 1980’s. Again, the primary culprit was the P/NE, which more than doubled from 15 in 1989 to 34 in 1999. As a result, investors who bought the S&P in 1989 earned a 18% annualized return over the next decade compared to the expected return of near 10%.
Conclusion
A long-term outlook based on dividends, earnings and valuations increases the probability of making a generally accurate assessment of expected returns than a focus on traditional one-year forecasts. This orientation reduces the temptation to be distracted by ephemeral factors. Therefore, we focus on the expected return for equities over the next decade.
We do not know how tight the fit will be between expected and actual returns on a going forward basis, but we do believe that this analysis warrants consideration in setting expectations for equity returns over the next decade. Currently, the expected annualized return over the next 10-years of 9.4% is near the long-term average of 10%, and well above the yield on high quality bonds.
Investors should recognize that the calendar year returns for the S&P 500 over the next decade will seldom be near this annualized expected return. We respect the comment attributed to Yogi Berra: “It's tough to make predictions, especially about the future.” However, historical probabilities indicate that investors will be rewarded for assuming the uncertainty of the timing and magnitude of equity returns over the long-term.
Mark F. Toledo, CFA is a Partner at Chicago Partners Wealth Advisors. He has been a wealth manager for over 35 years and has helped hundreds of individuals and foundations create better wealth management solutions.
1Zweig, Jason, Value Should Do Better. But When Is Anybody’s Guess, Wall Street Journal, April 27, 2018.
2JPM Guide the Markets, U.S., 2Q 2018, as of March 31, 2018, p 9.
Important Disclosure Information
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.
November 27, 2018
Expected Return Analysis for Equities
Estimating the long-term expected return for common stocks requires both quantitative tools and qualitative judgments. John Bogle described a useful method for this estimate 26 years ago in an article published in the Journal of Portfolio Management in 1991. This method identifies three sources of return for common stock investors: dividend yield, earnings growth and change in the price earnings (P/E) ratio.
Our adaptation of this model leads to a current expected return of 9.4% for the S&P 500 over the next decade. This current estimate is 3.3% below the model’s the 10-year expected return of 12.7% as of December 2008. The lower long-term outlook results from the near 135% rise in the S&P 500 price index over the past eight years. Investors often overlook the reality that expectations for future returns fall as prices rise.
Corporate Profits
The dashed line in Chart 1 shows the volatility of S&P 500 operating earnings over the past 30 years. During the early 2000’s recession, earnings fell 32% from $57 in September 2000 to $39 in December 2001. Operating earnings subsequently more than doubled to $89 per share in mid-2007. In the 2008 recession, earnings fell 56% from $89 in September 2007 to $40 in September 2009. Since then, earnings rose modestly above the trend line in early 2011 and then fell below in 2015.
The volatility of earnings shown in Chart 1 suggests that a smoothing process may provide a better foundation for valuation analysis. We “normalize” earnings by computing a least squares regression line (central value) for profits. The central value line represents smoothed earnings to show a constant growth rate. The solid line in Chart 1 shows this measure of normalized operating earnings (NE), which provides the earnings for our valuation analysis.
Price Earnings Ratios
The solid line in Chart 2 shows the price to trailing 12-months operating earnings (P/E) ratio for the S&P 500. The dashed line shows the price to normalized earnings (P/NE), which is computed by dividing the S&P 500 December 2015 average price of 2,091 by normalized earnings of $120. At the end of December, these price to earnings ratio were 19.7 for operating earnings and 17.4 for normalized earnings.
These ratios diverged dramatically during the 2008-09 bear market and recession. The solid line shows a near average price to earnings ratio of 18.6 and deeply depressed price to normalized earnings of 10.3 in February 2009. By September of 2009, the difference widened to between a very elevated 26 times depressed operating earnings and a subdued 13 times normalized operating earnings.
From a valuation perspective, was the market expensive or cheap in 2009? We believe that smoothing earnings to evaluate the price to normalized earnings provides a better answer to this question. As a result, our analysis suggested that the market was very attractive from a valuation perspective in early 2009. Currently, the price to normalized earnings ratio is modestly below the last 30 year average, suggesting a modestly attractive valuation level.
Expected Equity Returns
To estimate the expected return for equities over the next ten years, we minimize the number of subjective judgments by using current data and relying on regressions to long-term means. The estimate begins with the current dividend yield of 2.1%. We then add the past 30-year annualized growth rate for earnings of 6.7%. Finally, we compute the annualized contribution to the return resulting from the price to normalized earnings ratio (P/NE) returning to its long-term average over the next ten years. As of December 2015, the change in P/NE from the current 17.4 to the 30-year average of 18.4 by December 2025 contributes 0.6% per year to the expected return. The combination of these components produces the current expected return of 9.4% for the S&P 500 over the next decade.
Chart 3 provides a graph of the actual (solid) verses expected (dashed) equity returns. The actual results represent the 10-year annualized return over the previous decade. For example, the plot for the solid line of -1.5% in December 2008 means that an investor, who bought the S&P in December 1998, would have earned a -1.5% annualized return over the ensuing decade (December 1998 to December 2008). At the other extreme, investors earned a 19.0% annualized return from December 1988 to December 1998 as shown by the plot point of the solid line for December 1998.
A visual inspection of Chart 3 shows that the expected return (dashed line) was well above the actual return (solid line) in the mid-1970s. For example, an investor who bought the S&P 500 in December 1964 realized a return of near zero over the next decade versus the expected annual return of 5.7%. The primary reason for this under-performance was that the P/NE contracted more than anticipated from near 20 in December 1964 to 8 in December 1974.
In contrast, the model under-estimated returns for investors who bought in the late 1980’s. Again, the primary culprit was the P/NE, which more than doubled from 15 in 1989 to 34 in 1999. As a result, investors who bought the S&P in 1989 earned a 18% annualized return over the next decade compared to the expected return of near 10%.
Conclusion
A long-term outlook based on dividends, earnings and valuations increases the probability of making a generally accurate assessment of expected returns than a focus on traditional one-year forecasts. This orientation reduces the temptation to be distracted by ephemeral factors. Therefore, we focus on the expected return for equities over the next decade.
We do not know how tight the fit will be between expected and actual returns on a going forward basis, but we do believe that this analysis warrants consideration in setting expectations for equity returns over the next decade. Currently, the expected annualized return over the next 10-years of 9.4% is near the long-term average of 10%, and well above the yield on high quality bonds.
Investors should recognize that the calendar year returns for the S&P 500 over the next decade will seldom be near this annualized expected return. We respect the comment attributed to Yogi Berra: “It's tough to make predictions, especially about the future.” However, historical probabilities indicate that investors will be rewarded for assuming the uncertainty of the timing and magnitude of equity returns over the long-term.
Mark F. Toledo, CFA is a Partner at Chicago Partners Wealth Advisors. He has been a wealth manager for over 35 years and has helped hundreds of individuals and foundations create better wealth management solutions.
Important Disclosure Information
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.