A dimmer future for equity returns

Bond guru Bill Gross caused a stir when he declared that the “cult of equity” is over and that stocks no longer can be expected to return 6.6% a year above inflation in the long run. His declaration could be easy to dismiss. After all, the managing director and co-chief investment officer of Pacific Investment Management Co. LLC is a bond manager. So what does Mr. Gross know about equities? Even as a bond manager, he has made mistakes. Last year, Mr. Gross anticipated the end of the bond rally, but bond prices have continued to rise, largely because of the European economic crisis. But he is just the latest of a number of investment experts who have warned that stock returns in the future will be lower than they have been in the past, and these observers have reached their conclusions by different approaches. Given, however, that long-term bonds will be dangerous if interest rates rise, investment advisers and their clients are between a rock and a hard place. Mr. Gross bases his conclusion on the argument that stockholders can't command 6.6% real returns long-term if the economy is growing at only 2% a year. In past decades, it was possible for them to earn those returns when the economy was growing at 3.5% a year, because real U.S. wages as a percentage of gross domestic product were declining, as had the corporate income tax burden, meaning that capital received a greater share of the GDP. This is unlikely to continue. In an article in January, Christopher Brightman, head of investment management at Research Affiliates LLC, reached a similar conclusion. He argued that equity returns historically have been composed of four fundamental building blocks: dividend yield, real growth in earnings per share, inflation and expansion of the price-earnings ratio.

EPS GROWTH

From 1871 to 2010, the annualized return of the U.S. equity market was 8.9%. The dividend yield of 4.6% provided more than half that return and 70% of its real return. The other important contributor to the total return was earnings-per-share growth, which averaged 3.8%, of which 2.1% was inflation. Multiple expansion contributed just 0.3% per year. Assuming a constant P/E, the real return of stocks is dividend yield plus earnings-per-share growth, Mr. Brightman wrote. The latter has averaged 1.7% since 1870 but has slowed to 1.5% a year in the past 100 years. Mr. Brightman noted that these numbers are below what Wall Street typically forecasts. Although there often are short periods of stronger earnings-per-share growth, they typically are followed by periods of negative growth. As of the end of last year, the 10-year expected annualized return for the equity market was 6%, according to Mr. Brightman. The return for a 60/40 portfolio would be 4.4%. “Financial plans for the coming decade should assume a 4% to 5% nominal return and a 2% to 3% real return,” he wrote.

EQUITY RISK PREMIUMS

Three British academics, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, approach the issue from the question of the equity risk premium — the return from taking equity risk. They studied the equity risk premiums in 29 countries and found that the average such premium was 4.4%. If, as now, the return on short-term government debt is almost zero, the return on equities will be little more than 4.4%. Mr. Brightman noted that the actual return over a decade can be quite different from the expected return calculated at the beginning of the decade because of unexpected developments. However, financial advisers should consider all the evidence pointing toward lower equity returns as they develop plans for their clients. They also should be mindful of the warning at the bottom of Mr. Gross' article: “The easiest way to produce 7% to 8% yields for bonds over the next 30 years is to inflate them as quickly as possible to 7% to 8%! Woe to the holder of long-term bonds in the process! Similarly for stocks, because they fare poorly, as well, in inflationary periods.”