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What Long-Term Return Should We Expect On large-capitalization Stock Market Indexes?
This is a crucial question. Investors putting their money into stocks need to understand what long-term average return they can reasonably expect.
This article shows that a reasonable estimate for the average long-term compounded stock market return is currently no more than 7% to 8% (before trading and management costs) on large-capitalization stocks. This is based on U.S. data, but would also apply very similarly to Canada.
Many analysts forecast the long-term average return based strictly on historic returns. For example, the Dow Jones Industrial Average (including reinvested dividends), has returned a yearly average of about 11.3% per year since 1930. On a compounded basis this is equivalent to a steady return of 9.5% per year compounded. (Compounded returns were lower than average returns due to the impact of volatility).
9.5% per year as a compounded long-term average sounds reasonably comforting, although not what investors would hope for.
However, other analysts (most notably Warren Buffett in Fortune Magazine November 22, 19991) argue that future long-term stock market returns can be estimated based on GDP growth and the dividend yield.
The math is simple, according to Warren Buffett1 and others, we can roughly forecast the long-term expected return from major large-capitalization stock market indexes as:
Expected real GDP Growth + Expected Inflation + Expected Dividend Yield
The advantage of this simple method is that long-term forecasts of the three variables are available.
Today, a reasonable estimate of long-term expected large-capitalization stock market returns according to this formula is:
3 to 4% for real GDP growth + 2% for inflation + 2% for dividend yield = 7 to 8% long-term total return on stocks.
Equivalently; 5 to 6% for nominal GDP growth + 2% for dividend yield = 7 to 8% long-term total return on stocks.
Many of us might describe a 7 to 8% long-term average compounded stock market return as being "scary-if-true". And it is particularly scary when we consider that we need to deduct trading and management fees of about 1% to 3%,and we also need to deduct something for income taxes.
But are stock market returns really related to GDP, inflation and the dividend yield in this way? What does history tell us? The graph below provides the answer based on data for the Dow Jones Industrial Average, which is a large-capitalization stock index. The graph is based on rolling 30 year holding periods to simulate actual investor experience over different time periods.
In fact, history tells us that long-term stock market returns on the DOW were actually consistently lower than the growth in GDP plus inflation plus the dividend yield. The notable exception is that in the 30 year rolling periods ending in 1999 through 2006, the DOW return, at over 12% (the red line here), exceeded the growth in GDP plus the compounded average dividend yield.
The DOW total returns line is "smoothed" by taking an average of three years at the beginning and end point. This eliminates some of the volatility due to sharp annual moves in the DOW and allows a better view of the underlying trend.
Interpreting the lines based on 30-year rolling data above can be difficult. A more direct view of the Dow earnings versus GDP is shown below.
This graph shows the steady growth in U.S. GDP (blue line) versus the growth in the earnings of Dow Jones Industrial index which are more volatile but which also rose steadily in the long-run. The slope of the earnings line is lower than that of the GDP line. Thus, stock market earnings growth is driven by growth in GDP, in the long run, but is slightly lower.
A 30-year rolling holding period graph is also provided based on data for the S&P 500 as compiled by Ibbotson Associates in their Large Stock Index2. The pattern was remarkably similar to the DOW graph although the total returns on the S&P 500 lagged the GDP + Dividends figure by a smaller amount compared to the DOW data.
What Does This Imply For Future Long-Term Returns In The Market?
For 30 year periods starting today we should expect the nominal GDP plus dividends figure to be only about 7%. This low level is driven by today's very low interest rate outlook, low inflation outlook and relatively modest real GDP growth outlook. Due to the historical and logical relationship of large-capitalization stock returns being no greater than the sum of GDP plus the dividend yields, we should not expect large-capitalization stock returns to exceed about 7%. And this is before trading and management costs and before any income taxes.
We would have to adjust our expected returns figure if we thought that today's stock market values were very high or very low according to historical norms. However, that does not appear to necessarily be the case today and no adjustment seems warranted.
The result is that our "scary-if-true" estimate of 7% is not only reasonable but in fact may be biased high since actual large-capitalization total stock earnings and returns historically lags the sum of GDP growth plus the dividend yield over 30 year periods.
As mentioned, I first heard this theory from Warren Buffett and the data seems to prove his theory. This relationship only holds over long periods such as 30 years or more.
July 10, 2003 Shawn Allen, CFA, CMA, MBA, P.Eng.
InvestorsFriend Inc. Updated February 14, 2006
www.investorsfriend.com
1. Warren Buffett in Fortune Magazine, November 22, 1999, said:
Let's say that GDP grows at an average 5% a year - 3% real growth, which is pretty darn good, plus 2% inflation. If GDP grows at 5%, and you don't have some help from (declining) interest rates, the aggregate value of equities is not going to grow a whole lot more. Yes, you can add on a bit of return from dividends. But with stocks selling where they are today (this was 1999), the importance of dividends to total return is way down from what it used to be. Nor can investors expect to score because companies are busy boosting their per share earnings by buying in their stock. The offset here is that the companies are just about as busy issuing new stock, both through primary offerings and those ever present stock options.
At the May 2001 Berkshire Hathaway annual meeting, Buffett again spoke of long-term returns based on 5% for GDP and he estimated the dividend yield at 1.5% at that time. And he noted that this (6.5%) return would be before the investor's trading costs.
2. The Ibbotson Large Stock return figures are from the Stocks, Bonds, Bills and Inflation Yearbook by Ibbotson Associates. They indicate that the "large company stock total return index is based on the S&P Composite Index". Since 1997, Ibbotson has obtained its data directly from S&P. Prior to 1997 the dividend or income return was calculated by parties other than S&P. Consult the Ibbotson Yearbook for further discussion.
