Stocks Are Likely To Remain The Best Asset For Building Wealth

July, 2016
S&P 500: 2099

OUTLOOK MEMORANDUM
Stocks Are Likely To Remain The Best Asset For Building Wealth

Investors traditionally have been taught that stocks are a preferred asset for building wealth because their annual returns have averaged 10% per year over the past 90 years. In fact, annual stock returns also consistently have averaged about 10% over shorter periods such as the past 50, 40, 30, and 25 years. This reflects a close and persistent relationship between our economy’s long-term growth, averaging about 6% per year, and the earnings of the companies in the S&P 500, which have followed this economic growth, rising at a 6-7% rate. Stock prices have followed company earnings and have risen at similar, though slightly faster, rates. The resulting 7-8% stock price gains plus dividends averaging 2-3% have produced total returns from stocks averaging 10%. Over the past 20 years, however, nominal economic growth has slowed from 6% to about 4% and stock returns similarly have slipped by two percentage points to about 8%. During the coming decade, real economic growth is likely to remain low at about 2.2% because the low birth rates of the past 30 years and the retirements of Baby-Boomers are likely to keep Labor Force growth depressed. Adding average inflation of about 2.5% to real growth of 2.2% means nominal economic growth may average about 4.7% per year. In this environment, S&P 500 earnings are likely to grow at about a 6% rate, and stock prices should follow earnings up at a similar rate. Adding an assumed dividend yield of about 2.5%, we conclude that stock returns might average about 8.5% per year over the coming decade, well above expected bond returns of 3-4%.

When our generation of investors came of age during the late-1960s, we were taught that common stocks were the preferred securities class because they provided long-term returns that averaged about 10% per year, well above bond returns. In fact, over the 43 years for which we had data at that time (1926-1968), large-cap stocks, as measured by the S&P 500 Index, had returned a 10.2% compound average annual return versus 3.0% for Intermediate- term US Government bonds. This was a useful lesson as the S&P 500 has returned a similar 9.8% per year over the 47 years since then despite periods of high-inflation, low-inflation, interest rate spikes, wars, bank failures, inter-national crises, and political scandals. Thus, stocks now have had an average return of 10.0% for the past 90 years (1926-2015). But, with the stock market having sustained two 50% bear markets since 1999 (the 2000 dot- com tech bust and the 2008 sub-prime financial crisis), S&P 500 returns have averaged 8.3% per year for the past 20 years, below the longer- term 10%. We sense that many think that stock returns over the past two decades have been even lower than this, and it seems that there is considerable doubt that stocks can return much more than 5% per year over the coming decade. We think it is useful for us to explore this subject of future stock returns in this Outlook.

Based on our analysis, slower economic growth and low inflation are likely to produce average annual returns for the S&P 500 over the coming decade that fall short of the historical 10% level, but will remain in the 7-9% range that they have averaged for the past twenty years. We think this is considerably better than many currently expect. This Outlook will discuss complex future developments, and, of course, all the usual caveats about financial forecasts must apply to this discussion.

Daily, weekly, and even monthly changes in stock prices truly are random, and betting on such changes has much in common with casino gambling. Over multi-year periods, however, individual stock prices generally reflect the earnings performance of the underlying companies, and the returns generated by a broad stock market index like the S&P 500 reflect the performance of the US and world economy.

Over longer periods, stock returns have reflected our economy’s growth …, The data in the table below illustrate the close links between economic fundamentals and longer- term stock returns. For example, in the first row of the table (Last 50 Years), the first column indicates that the US Labor Force (i.e., the number of workers in our economy) increased at a 1.5% annual rate during those years. Since our economy was shifting from being manufacturing-based to service-based during this period, and since the average workweek in services is shorter than in manufacturing, the Total Hours Worked by all US workers increased at a slightly slower 1.21% annual rate as shown in the second column. The GDP of our economy (the value of all goods and services produced) is roughly equal to the total hours worked by all workers times the amount of work produced by the average worker per hour (i.e. productivity). The third column shows that worker Productivity increased at a 1.85% annual rate over the past 50 years as more efficient machinery, computers, and worker education enabled employees to be more productive. Thus, as shown in the fourth column, this combination of growth in the Total Hours Worked combined with increased worker Productivity to generate average annual growth of 2.82% in Real (inflation-adjusted) GDP. Inflation during these 50 years averaged 3.6% per year (Column 5). When this inflation is added to the 2.82% Real Growth, we get Nominal (includes inflation) GDP growth of 6.52% per year (Column 6). This means that the US economy grew at about a 6.5% annual rate during these 50 years.

… as S&P 500 earnings and stock prices rose along with the economy. Not surprisingly, the earnings of the companies comprising the S&P 500 tracked the growth of the broad economy over this period, rising at a 6.45% rate (Column 7). This profit growth then was translated into a similar rate of stock price appreciation with stock prices, as measured by the S&P 500, increasingata6.39%annualpace(Column8). Dividend yields averaged 3.28% over this period (Column 9). When these dividends were added to the average annual S&P 500 price gains, the average total return of the S&P 500 rose to almost 10% per year (9.67% in Column 10).

chart5

Long-term stock returns generally exceed Government bond returns by at least 3%. Column 11 of the table shows that Intermediate-term US Government bonds have returned an average of 6.65% over the past 50 years. Investors generally require a higher annual return from stocks than from Government bonds as compensation for assuming the greater risks of stocks. This additional required return is called the “Risk Premium” of stocks. The Risk Premium of the S&P 500 over this 50-year period has been 3.02% per year as shown in Column 12 (Column 10 – Column 11).
The remaining five rows of the table highlight that the relationships between key economic variables and security returns discussed for the 50-year period also can be observed over the past 40, 30, 25, 20, and 10 years. Thus, there is persistent economic logic underlying the long- term returns from stocks.

As economic growth has slowed in recent decades, so has the pace of S&P 500 earnings and stock price growth. Due to slowing birth rates and the retirements of the oldest of the large Baby-Boomer generation, our table shows progressively slower average annual growth in the Labor Force and in Total Hours Worked as we proceed from the past 50 years to the past 40, 30, 25, 20, and 10 years. Productivity growth remained at close to 2% (1.79%-2.07%) until the past 10 years, when it dropped sharply to a 1.2% rate. A slowdown over this period in business capital investment is thought to be a causative factor in this, but this sharp decline in productivity growth is not well-understood.

Our table shows that the progressively slower growth in the Labor Force, Total Hours Worked, and Productivity in recent decades has produced a similar progressive slowing in Real GDP growth from 2.82% for the last 50 years to 1.37% for the last 10 years (Column 4). At the same time, Column 5 indicates that the average annual rate of inflation has slowed progressively from 3.6% over the past 50 years to1.7%overthepastdecade.Thus,withboth Real GDP growth and inflation slowing, the rate of growth in the overall economy as measured by Nominal GDP (Column 6) also has slowed progressively from 6.52% over the past50yearsto3.10%overthepast10years.

While S&P 500 earnings growth remained in a 6-7% annual range over most of the past 50 year period, the slowdown in overall economic growth since 1995 has pulled S&P 500 earnings growth down to about a 5% pace (Column 7). Stock prices, as measured by the S&P 500 Index, have followed their earnings upward, rising at rates over the past 40 years that slightly exceeded the slowing earnings growth rates (Column 8). And, when the dividends in (Column 9) were added to the annual price gains for the past 40, 30, and 25 years, S&P 500 Total Returns remained near 10%, in a 9.99%-11.37% range.

Slowing economic growth has had a pronounced effect on stock returns during the past 20 years. Since 1995, Nominal GDP and S&P 500 earnings growth declined to roughly 4% and 5%, respectively. S&P 500 annual price gains also slipped by about two percentage points from about 8% to 5%-6%. When dividends of about 2.0%-2.25% were added to these reduced price gains for these most recent 10 and 20-year periods, S&P 500 Total Returns slipped to about 7-8%. Nonetheless, as shown in Columns 11-12, the Risk Premium of stocks over Government Bonds has remained at about 3.5%.

With the returns on stocks over the last 30-90 years having held solidly near 10%, our instinct has been to anticipate this trend to continue. This normally would lead us to expect periods during which stock returns have been less than 10%, as they have during the past 20 years, to be followed by periods during which stock returns averaged more than 10%. But, with Labor Force and Productivity growth forecast to remain sluggish, and with inflation likely to stay historically low, we must recognize that the returns from stocks over the coming decade are more likely to remain a little below their long- term historical averages than they are to accelerate.

Economic growth is likely to continue trailing historical levels over the coming decade. The US Bureau of Labor Statistics forecasts that US Labor Force growth will average 0.5% over the coming decade and that with productivity increasing back toward more normal levels near 2%, Real GDP growth will average 2.2%. The Federal Reserve currently is trying to get annual inflation back to a 2% annual rate, and over the next 10 years we think it might average near 2.5%. Thus, average Nominal GDP growth might average about 4.7% (2.2%+2.5%), similar to its reduced rate over the past 25-30 years.

Another decade of slow economic growth seems likely to keep average stock returns for the next ten years near 8.5%. Using these relationships, we can better understand the level of returns that a major stock market index like the S&P 500 might provide over the next ten years. Since S&P 500 earnings growth generally has been 1-2 percentage points per year faster than Nominal GDP growth, S&P 500 earnings might rise at about a 6% annual rate over this period. (4.7% + 1.5% = 6.2%).

In this low-growth, low-inflation environment, we think the S&P 500 Index would be likely to track its earnings as it has over the last 50 years, rising at about a 6% rate. This may be a conservative assumption since our table shows that for each of the periods listed over the past 40 years the S&P 500 has risen by 0.5% to about 1.0% percent per year faster than have its earnings. The S&P 500 Dividend Yield currently is about 2.2%. Our guess is that this Dividend Yield might equal about 2.5% over the coming decade, bringing the Total Return on the S&P 500 to about 8.5% per year.

Despite getting a return below 10%, stock investors will get a 4.5% Risk Premium to Government bonds. Historically, Govern- ment bond yields have ranged between 1% and 2% above the inflation rate. Thus, if we assume that inflation averages roughly 2.5% over the coming decade, Government bond returns should average about 4%. Given our outlook that the S&P 500 might return about 8.5% per year, a 4% bond return would result in a Risk Premium of about 4.5% for stocks (8.5% – 4.0% = 4.5%). This is reasonable and, as shown in Column 12, consistent with the Risk Premium for stocks over the past 25 years as well as below the 4.88% risk Premium of the past 90 years.

While we think this analysis has been useful in explaining the relatively consistent long-term returns on stocks spanning all sorts of economic and political environments, it also highlights the many variables with the potential to affect future stock returns. If Labor Force growth were to exceed the current forecast because immigration policy was liberalized, or if technological advances produced large gains in Productivity, GDP and S&P 500 earnings growth could be faster than our forecast, and stock returns likely would be higher. On the other hand, if current political forces lead the world away from policies favoring free-trade and the movement of people and capital, replacing them with harmful protectionist policies, economic growth and future stock returns might fall short of our forecast. We conclude by noting, however, that with 90 years of precedents, average annual stock returns in the 7-10% range for the coming decade seem like a pretty good bet.