Consider the Components of Equity Returns

Wednesday, October 19th, 2011

The raison d’être of investment or wealth management is to maintain, or hopefully improve, one’s standard of living, i.e. to earn a real return on the investment amount. This sounds easy enough if one considers that the S&P 500 Index (and its predecessors prior to 1957) delivered a nominal return of 8.8% per annum from January 1871 to October 2011. With an average inflation rate of 2.2% per annum over the period, this meant a real return of 6.6% per annum.

Yes, I can hear many readers arguing that much better returns can be generated by “playing” the market cycles, especially given the fact that the S&P 500 has made no headway since 1998. Ah, the art of market timing! But keep in mind that very few people have succeeded in consistently outperforming the market over any extended period of time, especially once costs and taxes are factored in.

Let’s go back to the total nominal return of 8.8% per annum and analyze its components. We already know 2.2% per annum came from inflation. Real capital growth (i.e. price movements net of inflation) added another 1.9% per annum. Where did the rest of the return come from? Wait for it, dividends – yes, boring dividends, slavishly reinvested year after year, contributed 4.6% per annum. This represents more than half the total return over time!

Have a look at the following chart:

The numbers are summarized below in table format.

Source: Plexus Asset Management (based on data from Prof Robert Shiller and I-Net Bridge).

In an environment characterized by increasingly shorter investment horizons, the concept of compounding sounds so passé, but it remains one of the most important principles governing investment. The time has perhaps come to look beyond the short-term noise and focus on good old stock picking, and specifically those companies with strong balance sheets that will be growing their dividends over time with a reasonable degree of certainty. After all, compound growth has not without reason been referred to as the eighth wonder of the world.

Tags: Amp, Asset Management, Average Inflation Rate, Balance Sheets, Bridge, Compound Growth, Dividends, E Price, Format Source, Headway, Horizons, Market Timing, Period Of Time, Predecessors, Return Investment, Robert Shiller, Sounds, Stock, Stocks, Term Noise, Wealth Management
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US Stock Market Returns – What is in Store?

Thursday, April 28th, 2011

Stock market movements since the start of the credit crisis have been characterised by relatively high volatility as uncertainty became paramount. And as new pieces of the economic recovery puzzle are added every day, investors are increasingly struggling to make sense of the most likely direction of stock prices.

It seems to be a case of so many pundits, so many views. Has the market started topping out and is a primary bear market about to resume, or will the secular bull market merely be correcting the strong rally that commenced in March 2009, before moving higher? Or is a “muddle-through” trading range in store?

It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with not many people actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns, as done by Jeremy Grantham’s GMO. Our study covered the period from 1871 to April 2011 and used the S&P 500 (and its predecessors prior to 1957). In essence, PEs based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.

In the first analysis the PEs and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).

The cheapest quintile had an average PE of 8.9 with an average ten-year forward real return of 11.0% per annum, whereas the most expensive quintile had an average PE of 25.5 with an average ten-year forward real return of only 2.1% per annum.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the PEs divided into smaller groups, i.e. deciles or 10% intervals (see diagrams A.2 and A.3).

This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is that the ten-year forward real returns on investments made at PEs between 12 and 19 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to and extension of an earlier study by GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.

Based on the above research findings, with the S&P 500 Index’s current ten-year normalised PE of 27.1% and dividend yield of 1.8%, investors should be aware of the fact that the market is by historical standards in “extreme overvaluation” territory. As far as the market in general is concerned, this argues for unexciting long-term returns, and possibly a “muddle-through” trading range for quite a number of years to come.

Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current valuation levels. As a matter of fact, there is a distinct possibility of below-average returns.

Tags: Bear Market, Creating Wealth, Credit Crisis, Economic Recovery, Investment Returns, Jeremy Grantham, Muddle, Patient Approach, Pe Ratios, Predecessors, Price Earnings, Pundits, Quintile, Rallies, Secular Bull Market, Stock Market Returns, Stock Prices, Stock Valuations, Store Stock, Volatility
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US stock market returns – what is in store?

Monday, August 30th, 2010

Stock market movements since the start of the credit crisis have been characterised by relatively high volatility as uncertainty became paramount. And as new pieces of the economics puzzle are added every day, investors are increasingly struggling to make sense of the most likely direction of stock prices.

It seems to be a case of so many pundits, so many views. Has the market started topping out and is a primary bear market about to resume, or is a new secular bull market merely correcting the strong rally that commenced in March 2009, before moving higher? Or is a “muddle-through” trading range in store?

It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with not many people actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns, as done by Jeremy Grantham’s GMO. Our study covered the period from 1871 to August 2010 and used the S&P 500 (and its predecessors prior to 1957). In essence, PEs based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.

In the first analysis the PEs and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).

The cheapest quintile had an average PE of 8.6 with an average ten-year forward real return of 10.9% per annum, whereas the most expensive quintile had an average PE of 24.2 with an average ten-year forward real return of only 2.4% per annum.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the PEs divided into smaller groups, i.e. deciles or 10% intervals (see diagrams A.2 and A.3).

This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is that the ten-year forward real returns on investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to and extension of an earlier study by GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.

Based on the above research findings, with the S&P 500 Index’s current ten-year normalised PE of 19.3% and dividend yield of 2.1%, investors should be aware of the fact that the market is by historical standards above “average value” territory. As far as the market in general is concerned, this argues for unexciting long-term returns, and possibly a “muddle-through” trading range for quite a number of years to come.

Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current valuation levels. As a matter of fact, there is a distinct possibility of below-average returns.

Tags: Asset Management, Bear Market, Creating Wealth, Credit Crisis, Investment Returns, Jeremy Grantham, Muddle, Patient Approach, Pe Ratios, Predecessors, Price Earnings, Pundits, Quintile, Rallies, Secular Bull Market, Stock Market Returns, Stock Prices, Stock Valuations, Store Stock, Volatility
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The Oddities of this Recession (Rebecca Wilder)

Wednesday, August 5th, 2009

Rebecca WilderThis post is a guest contribution by Rebecca Wilder*, author of the of the News ‘n’ Economics blog.

It is not a rule that the personal saving rate rises during a recession, just in this one. Take a look at the cumulative trajectory of the personal saving rate for this Great Recession compared to its predecessors, as represented by the “average recession” since 1960.

The chart illustrates the cumulative growth of the saving rate throughout the recession period and during the twenty-four months (of recovery) following the recession for the current cycle and the average over the latest 7 cycles. Note: convenience only, I call the end of the current cycle at point 0 or June 2009. I do not believe that the recession is actually over in June.

Recently, the average saving rate, which is estimated monthly by the Bureau of Economic Analysis, surged since the onset of the longest recession in the post-War era. Consequently, the sharp ascent of the marginal saving rate is wreaking havoc on personal consumption spending, and thus, GDP.

Interestingly, current saving trends mark opposing behavior relative to the “average” recession occurrence, which is the indexed trajectory of the average saving rate spanning the 7 recessions since 1959. The saving rate drops during the average recession, and stabilizes thereafter. So far, the saving rate has a -50% correlation with the saving trend during “average recession”, and is moving against the broader historic trend. If saving continues its ascent, one can discount quite significantly the possibility of an “average recovery” to a recession this deep (i.e., V).

* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

Tags: Ascent, Assistant Professor, Bureau Of Economic Analysis, Correlation, Cumulative Growth, Doctorate, Economist, GDP, Occurrence, Oddities, Personal Consumption, Point 0, Post War, Predecessors, Rebecca, Recession, Recessions, Trajectory, Twenty Four Months, Wreaking Havoc
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