Indiscriminate Selling Continues to Bring Expected Returns Higher

The world sure seems bleak right now. At least that's what the media is intent on conveying, as it produces an almost endless stream of bad news – home prices falling, food and gas prices rising out of control, stocks (and 401k balances) down significantly amid an uncertain and fragile economic situation. What is lost in the noise, however, is that our economy is in good fundamental shape. Because most people still have jobs, they largely continue to pay their mortgages despite fears of widespread defaults. True, some areas have been hit especially hard by problems in the housing market. But this is not the entire country! The average consumer is pretty well leveraged, and may realize that ratcheting back spending is a good idea, even though it may be painful to do so. Consumers ratcheting back their spending will affect the unemployment rate as the most discretionary items are cut from household budgets (especially as more people start to budget). Yet the situation we're seeing now is not really anything new.

While the widespread problems in the housing market are a relatively new phenomenon, it is just a different version of problems we have experienced in the past. This time it is the real estate market, last time it was Internet stocks, in the early 1980s with was runaway inflation. All brought stock prices down to levels that would, years later, look like a bargain. It is my contention that this time is no different. Like a B movie, the specifics may have changed, but the basic story is about the same.

What we won’t hear much about is the incredible opportunities available to investors right now. Home prices are lower, yes. But for those with available purchasing power, very good income-producing real estate is available at lower and lower prices. Cap rates (the assumed rate of return on property based on net operating income) are rising across the country as many of the former sources of financing with loose lending terms have shut down. Stock prices are now more than 20% below their highs of last year. Many of the world’s finest companies are selling at low multiples to long-term free cash flows. The time to invest new money is now. Asset prices may continue to get cheaper in the short-to-intermediate term, but those who have the courage of their convictions and invest now might just look like geniuses five years hence.

Amid all the uncertainty, what can we expect the stock market to look like in 10 years? I ran a few numbers, assuming different scenarios (none of which might illustrate what will actually happen, mind you) but using the same basic underlying idea. I’m assuming that earnings in the future continue to grow at about 6%, or the long-term trend rate. I then made separate lines of assumptions – that ending price-to-earnings ratios are 15, 20, and 25 ten years from now. Given these assumptions, what can we expect for returns from current market levels? The table below illustrates.

If P/Es stay about where they are, or 20 times earnings, we might expect annual returns of around 10% annually including dividends. If P/Es decline to 15, this number drops to 7.5%. At 25, we can expect annual returns of 13%, but when stocks have hit a P/E of 25 they have usually not stayed there for long. In addition to the above, I made another assumption not listed on the chart; that is an ending P/E of 10. In this scenario, stocks should return only a cumulative 10.9% over ten years, or 1% compounded annually, for a total return of 3.3% annually from current market levels. The only way I see us getting to a P/E of 10 is in a highly inflationary environment like the early 80s and/or one where the economy is stagnant. Which scenario ends up being close to the actual result is anyone's guess.

Lower valuations generate higher future returns despite the short term pain. The table below illustrates what these same numbers would have looked like from the highs of October 2007, when the S&P closed at 1,565.

The difference is striking. Falling stocks prices have added about a cumulative 34% (3% annually) to the possible ten year returns from stocks. That is, a person investing now stands to earn an incremental 3% annually versus another person investing at the October highs - regardless of what the market does over the next ten years!



Over the long-term, stocks track earnings. The above chart show the last twenty years (1998-2008) of actual earnings, normal, or trend, earnings, and stock prices. The normal earnings line is the trend line, because it assumes earnings grow 6% annually without any volatility. The actual S&P earnings per share has tracked this line over time, and although it has diverged meaningfully at points, it has always seemed to tend back to it after diverging. Stock prices also track this trend, excluding the irrationally exuberant period of the late 1990s. Betting on stocks is a bet on future earnings. So if you believe that over the longer-term our economy will perform about as it has in the past, stock appear to offer reasonable returns from these levels. But these levels also appear to offer excellent opportunities to buy individual stocks that will perform significantly better than the overall market in the years to come.