Here’s why market returns will be coming down

Will market returns be lower in the future? It is my strong suspicion that they will. Even assuming that the re-markable recent rate of growth in the earnings of corporate America slackens to levels well above historical norms, it seems almost preordained that future market returns will recede. For what creates market returns is not very complicated.

Stock returns are the result of the initial cash dividend yield, the future rate of earnings growth, and the multiple that investors place on the earnings resulting from that growth. In the long run, however, it is earnings and dividends — investment fundamentals — that determine return, not the price-earnings multiple or the element of speculation. Over the past 127 years for which we have reliable statistics, the fundamental real return on stocks averaged 6.7%; a return including the speculative element averaged 7.0%.

But in the shorter term, speculation can make a huge difference. For example, at the beginning of the great bull market in 1982, Standard & Poor’s 500 stock index stood at 102 and sold at 7.3 times earnings. If stocks today were valued at this same P/E ratio, the index would be at 340, the result of the fundamentals of dividend yield and earnings growth. But its actual level is above 1400. More than 1000 points of the 1300-plus increase in the 500 Index, then, has been attributable to the change in the investors’ attitudes from deep pessimism to wild-eyed optimism.

Here is how the market returns of the past two decades have developed. In 1980, the dividend yield on the S&P 500 was 4.5%; per-share earnings have grown from $15 to $47 during the two-decade period, a rate of earnings growth of 5.9%; and the stock market is valued at 28 times earnings. That combination has produced an annual total return of 17.4% since 1980 began — the highest by far for any two-decade period in history, and the largest single contributor was the increase in the price-earnings ratio.

One thing that we know is that dividend yield will not provide a 4.5% increment to the market’s annual return in the years ahead. The present dividend yield is but 1.3%, which means, mathematically speaking, that more than 3 percentage points of the market’s annual return during the two-decade bull market will have to be replaced by 3 percentage points of extra earnings growth, to a 9% rate, to get the same investment return of 10.4%. If we are to see a continuation of 17% annual returns, we’ll need help from speculation, too, in that the market’s price-earnings ratio would have to rise from today’s level of 28 times to a mere 54 times! An increase to such a level would seem improbable, to say the least.

Realistic Expectations

What might be a realistic expectation for the coming decade? We begin with a 1.3% yield; let’s assume a solid earnings growth of 8% a year (it could be more, or less; in a heavy recession, earnings could even decline). That’s an 9.3% return, before we factor in the price/earnings multiple, which is at an all-time peak today.

Let’s assume it might ease back to 20 times. (It could remain unchanged; it could rise. But the long-term norm is 15.5 times.) That change would knock 3.3 percentage points off the market’s return, bringing it to 6% (which, I should point out, is the same estimate Warren Buffett arrived at in a recent Fortune article using a slightly different methodology. But Bogle and Buffett does not equal certainty. Anything can happen in the stock market).

And I doubt that I have to remind you that our 6% estimates are less than the plus-7% return available on high-grade bonds today. (I know that stocks have rarely provided lower returns than bonds over a decade; but I remind you that the stock market is not an actuarial table.) After all we’ve been given in these fabulous past two decades, it would be hard to feel crestfallen if such an economic return is all that the stock market gives us. What would make it harder to swallow for mutual fund investors is that, if the economics of the fund managers remain intact, fund industry costs of 2.5% a year would cut the economic return of the market by more than 40%, bringing the economic return of mutual fund investors to a measly 3.5%, and before taxes at that.

Mr. Bogle is founder and senior chairman of Vanguard Group in Malvern, Pa. This article was excerpted from an address he made at the University of Delaware late last year.