The sky isn’t falling yet — but think about inflation-indexed bonds

Last year marked an extraordinary end to a great century for U.S. stocks. Standard & Poor’s 500 stock index rose more than 20% for the fifth year in a row and the Nasdaq composite rose 86%, the best calendar year for a U.S. stock market in history. But even the more sedate returns for the entire century are pretty impressive. The S&P 500 posted an average annual real return (above inflation) of 7.5% in the 1900s, allowing a tax-free dollar invested in 1900 to grow to $1,260 in real terms. But that is history. What we need to know is what kind of century the 21st will be for stock market investors.

Many analysts and finance professors suggest our best guess for the future should be the past, and thus we should expect real returns of around 7%. Unfortunately, that might not be in the cards.

There are, in fact, two plausible outcomes for the stock market in the 21st century. The stock market can stay at current levels, dooming us to returns well below those of the 20th century, or the stock market can fall fairly soon to far lower valuation levels, setting the stage for returns that are strong enough to recoup our early losses and give average returns that meet or exceed the standards set by the last 100 years.

what produces returns?

Why? The case for 7% real returns sounds sensible enough. After all, if 100 years is not long enough to qualify as “the long run” then it’s hard to imagine what is. But the simple look at long-run returns ignores a critical issue: how we got those returns in the first place. Stock market returns do not come out of thin air. They come instead from three factors — dividends, earnings growth and price/earnings ratio change.

The historical average dividend yield for Standard & Poor’s 500-stock index in the 1900s was 4.7%. The rest of the return came from real earnings growth (1.8 percentage points over inflation) and an increase in market p/e from 16 in 1900 to 32 in 1999.

If the stock market is to repeat the trick of 7% real return over the next 100 years, it will have to do it with a notably different breakdown in the three factors.

The market’s current p/e, around 30, gives a limit on the amount of dividends that corporations can pay out. A p/e of 32 equals an earnings yield of about 3%.

It is out of this 3.1% that dividends and retained earnings (which lead to growth) come.

Historically, corporations have paid out around 60% of their earnings as dividends. Today the dividend payout rate is lower, with some of the difference made up possibly in stock buybacks, which are equivalent to dividends from a shareholder perspective. Let us assume that buybacks are raising the effective dividend yield from 1.1% to 2%, giving us a payout rate close to the historical average for stocks. It is worth emphasizing that the earnings yield really does provide an upper limit to the sustainable level of stock buybacks. Companies cannot increase their debt levels forever, so if we assume the indebtedness of corporate America does not increase without bounds, then investment, dividends and stock buybacks all have to come out of the same 3.1% earnings pool.

If stocks are to return a 7% real rate in the 21st century, therefore, we need to see far more of the return coming from earnings growth than we have seen historically. Absent a continually rising p/e (which would just make things that much tougher for investors in the 22nd century), earnings would have to grow at a 5% real rate for us to achieve a 7% real return for the century. This is unlikely to occur.

gdp growth getting tougher

Corporate earnings are, in the end, a piece of the overall economy. Historically, they have grown around the same rate as the economy. To achieve our 7% real return, corporate profits would have to grow much higher than the growth in the overall economy. Worse is the fact that the 21st century is projected to have much lower labor force growth than the 20th, making a given level of gross domestic product growth that much harder to achieve.

So let us give the new-era bulls their due and estimate productivity will grow at 2% in the next century, with the 0.5% growth in the 18-to-65-year-old age group the Census Bureau is projecting. This gives overall economic growth a 2.5% real rate, vs. a 5% real rate in corporate earnings.

Such a scenario is impossible. The ratio of profits to national income was quite stable in the past 100 years, around 11% of the total, with most of the rest going to workers. If profits were to begin growing at twice the rate of the overall economy, they begin to eat up more and more of the total income pie. Within 100 years, we would see profits passing 100% of national income, leaving late 21st century employees in the position of paying employers for the privilege of working. So 5% real profit growth is probably not in the cards. If instead we got a more plausible (but still quite optimistic) 2.5% real growth in profits, the total return to stocks over the century would be 4.5% real, or about 0.2% more than the risk-free U.S. Treasury inflation-protected bond is now yielding.

Does this mean that all hopes for a 21st century as good as the 20th are doomed? Not quite. We might not be able to get profit growth of a 5% real rate, but if we raise the yield on the market significantly, we could make do with a more reasonable 2.5% profit growth and still get a 7% real return from today. The trouble is that the way to increase the yield is to decrease the price. In this case we would need to decrease the price of the stock market by 63%. Then we could have 5.4% effective yields and 2.5% growth in the market for the following 99 years. The good news is that it gives us our 7% real return for the century. The bad news is we don’t break even on the stock market from 1999 yearend levels until 2013.

A 63% fall certainly would be devastating for today’s investors, but from a glass-is-half-full perspective, it at least gives a prudent long-term investor a pretty simple investment rule to follow. Sell your stocks now and invest in U.S. government inflation-protected securities. If stocks stay at current p/e multiples you’ll be getting about the same 4.5% real return they will, and if stocks fall to a level where they offer a significant return premium to bonds,you can always sell your bonds and go back into the stock market.

Mr. Inker is director of the asset allocation group at Grantham Mayo Van Otterloo & Co., an independent investment adviser in Boston. This article initially appeared in sister publication Pensions & Investments.