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:
- 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.
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