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What Should We Expect from Stocks?
The past year or so has provided a vibrant debate about the long-term returns stock market investors should expect. Part of this discussion has been driven by the long-term return assumptions used by public pension plans in the U.S. It’s also been driven by the great stock market performance of the past few years and how that should impact long-term expected returns. Further, some investors seem to be worried about the future of the stock market because of recent performance, fearing that we are “due” for another correction given their experiences in 2000-2002 and 2008.

Stock market returns basically come from three sources:

  • Dividends
  • Growth in earnings
  • Changes in the price/earnings ratio

When forecasting long-term stock market returns, it’s usually assumed that the price-to-earnings ratio won’t change. In reality it will change, but there’s no guidance to know whether it will go up (which increases return) or down (which decreases return). (Some might argue of course that if you were forecasting stock market returns in the late 90s, you should have forecasted the price-to-earnings ratio to go down. However, that period was definitely a special case.)

This leaves us with dividends and earnings growth. Looking at U.S. stocks, the dividend yield is about 2.1 percent. For international stocks, it’s currently about 3.2 percent. For earnings growth, there’s surprisingly minimal non-U.S. data. In the U.S., net-of-inflation earnings growth appears to have been about 1.5 to 2 percent historically.

So, where does this leave us? The above tell us that expected net-of-inflation returns for the U.S. stock market are about 4 percent and likely slightly higher than this for international stocks (yet another reason why international diversification makes sense). An astute reader might note that 4 percent is significantly lower than the long-term average return of the U.S. stock market. There are two reasons for this. One, the price/earnings ratio has gone up over the long-term history of the U.S. stock market, which has increased return. Two, the dividend yield has historically been higher in the U.S. than it is today.

Random Links and Commentary of the Week

I haven’t read any of these New Yorker pieces yet but they all look good: here, here and here.

Alec Baldwin interviews Thom Yorke from Radiohead.

Jared Kizer is the director of investment strategy for The BAM ALLIANCE. See our disclosures page for more information.
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Comments

Re: What Should We Expect from Stocks?

Pension plans do not think in the right way about expected returns. Expected returns of stocks do not make much sense without discussing at the same time what risks we should expect from them. Higher expected return might just mean higher expected risks! It is just as fundamentally wrong to think in terms of expected returns in the context of long term risky investment as it is for short term risky investment. Risky investments do not become safe merely because one invests over the long term--in fact, the dispersion of wealth increases with the length of the time one is invested, which means risk increases. Sure, on average, losses become less likely over the long term, however, losses that do occur may be much more severe.

A sound way to think about expected returns is the current savings rate, ie., how much to spend right now and how much to invest. It is (among other factors) a function of total wealth (human and financial capital) and expected return.

Hence, pension plans should use expected returns for one thing only: To continuously adjust the premiums participants have to pay. If expected return goes down, premiums need to go up, and vice versa. However, pension plans usually want to do the impossible: Take a fixed premium from participants, and yet achieve long term returns higher than what long term government bonds offer. Stocks, unlike long term government bonds, are not a sound instrument for long term planning, and should never be used for such purpose. I can only fully agree with Zvi Bodie on this.
at 4/21/2013 7:47 AM

Stocks and pension plans

I do agree that public pension plan accounting generally gets it wrong when it comes to expected returns. Pension plan liabilities are generally discounted by the expected return on the pension plan portfolio, which doesn't make much sense. The liabilities should be discounted, in my opinion, at a rate comparable to the rate the pension would pay to issue taxable municipal bonds, which would generally produce a much larger value for the value of the pension plan liability.

I don't agree, though, that stocks shouldn't be held by long-term investors like public pension plans. I think the stock allocations should be lower than they generally are since taxpayers may bear the costs of underfunding if stock returns disappoint, but I think it's reasonable to have an allocation to stocks, particularly for plans that are underfunded.

JK
at 4/22/2013 2:57 PM

Re: What Should We Expect from Stocks?

"I think it's reasonable to have an allocation to stocks, particularly for plans that are underfunded" IMO this is not an economically sound idea. Sooner or later, the risks WILL show up (otherwise they wouldn't be risks) and thus taxpayers WILL bear the costs. Risk does not decrease because you invest over the long term. Better make transparent those costs needed to fund the plans and pay them regularly than as a large lump sum once about each 100 years when stocks fail spectacularly. If plans are really underfunded, either pensions should be cut, or premiums should be increased, or taxpayers need to agree to fund them. When risks show up, they will do so under economic circumstances in which taxpayers will agree even less to bail out underfunded pension plans and will demand that pensions be cut. One is just delaying the decision to some stochastic point in the future.
at 4/23/2013 7:35 AM

stochastic stock

What Is a Technical Indicator?
A technical indicator is a series of data points that are derived by applying a formula to the price data of a security. Price data includes any combination of the open, high, low or close over a period of time. Some (www.seekingtechnicals.com) indicators may use only the closing prices, while others incorporate volume and open interest into their formulas. The price data is entered into the formula and a data point is produced.
For example, the average of the 3 closing prices is one data point ( (41+43+43) / 3 = 42.33 ). However, one data point does not offer much information and does not an indicator make. A series of data points over a period of time is required to create valid reference points to enable analysis. By creating a time series of data points, a comparison can be made between present and past lives. For (analysis purposes), technical indicators are usually shown in a graphical form above or below a security's price chart. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security.
at 8/4/2013 9:41 AM

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