In last week's column, I implored you to take the time to form an expectation about the future performance on your investments. An expectation is different from a forecast, in that an expectation deals with looking farther into the future than next quarter's mutual fund statement.
I closed that column by arguing that the wrong way to form an expectation about an investment is to look only at its historic rate of return.
Ten-year bonds have paid a total annualized return of 7.4 percent over the past 10 years. Should you expect to earn 7.4 percent over the next 10 years? Certainly not.
Ten-year bonds are only paying about 4.25 percent right now, so that's what you should expect to earn. If you expect to earn more than today's 4.25 percent on bonds, then you have formed an irrational expectation.
It's easy to form rational expectations for bonds. You can look up the yields in the newspaper every day.
While it is easy to develop an expectation for bonds and other forms of interest-bearing investments, stocks are a bit trickier. Stocks don't have a stated interest rate printed on them. Your returns are largely at the mercy of the companies you own and the markets.
There is one simple little calculation that should serve as the starting point. Over time, the U.S. economy grows at about 2-3 percent, plus inflation. Realize for a moment that the 3,000 or so public companies that make up the bulk of the stock market can only grow their earnings as fast as the whole economy grows.
This is an elementary concept, since corporate America cannot grow to become larger than the American economy.
So, if the economy grows at 2-3 percent plus inflation, how fast does the value of corporate America grow? Right. The total value of the stock market can only grow at a rate of 2-3 percent plus inflation.
In reality, it grows closer to 2 percent than 3 percent because a significant share of our total economic growth is generated by faster-growing privately held businesses, not public companies.
At any given moment in time, we should only rationally expect our stock values to grow by about 2 percent plus inflation. If inflation is 3 percent, then our stocks should grow at a 5 percent annual rate.
We get another source of return from stocks: dividends. The net dividend yield is around 2 percent, giving us a total expected return on stocks of 7 percent assuming inflation is 3 percent.
Any investor or adviser that does not accept this fundamental truth about stocks should be forced to march up and down Prospect Street with a sign around their neck that says, "I can't add."
Now, compare that 7 percent number to what the historic charts tell you to expect from stocks. Stock returns in the past few decades have been much higher than 7 percent, and it makes sense to ask why. First, dividends were far higher in the past, adding as much as 7 percent per year to our starting point instead of the 2 percent we get today.
In addition, inflation was higher and added to gross returns. But the single biggest reason that stocks paid double-digit returns in the recent past is the fact that the price-earnings multiple rose dramatically, from less than 10 in 1981 to more than 22 today.
The extreme expansion in the price-earnings multiple was a singular accident of history that will almost certainly not be repeated. Realize that to earn more than 7 percent on stocks indefinitely, the price-earnings multiple must grow without limit.
Such growth is, quite literally, impossible.
Achieving the same returns over the next 25 years that we got over the past 25 years will require the price-earnings multiple to expand to over 40. While that might happen, it is quite unlikely and should not be part of our expectations.
Starting from a rational expectation of only 7 percent today, we can rightly ask whether there are pressures pushing stocks above or below that figure. In 1981, the pressure was upwards since the price-earnings multiple was very low. Today, the price-earnings multiple is 50 percent above its long-term average, and the pressure on our 7 percent starting point is decidedly downward.
It is not a simple business to form a reliable expectation for stock returns. In the face of uncertainty, we need to go back to first principles and add up the numbers. We can adjust those numbers a little if we think there are compelling reasons to do so.