Ibbotson Readjusts His Long-Term Outlook!
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Is the consummate perma-bull turning bearish?
Investing is a tricky business. You have to be careful that you don’t get tunnel vision and “only see what you want to see”. This phenomenon destroys your objectively and can be devastating to someone in my business.
Allow me to provide an anology. Whenever you buy a new car, you immediately start noticing a proliferation of people driving your exact model of vehicle. It’s like everyone went out yesterday and bought your car.
So it is with Investment Management. You decide on a strategy and you start noticing all the “support” for your theory. Many advisors only pay attention to what “jives” with his or her own belief structure and dismiss everything else as balderdash. (I think the same goes for Religion, Politics and Fantasy Football – darn Daunte Culpepper!)
The cure (or at least an antidote) for me is to purposely seek out research that doesn’t coincide with my strategy and determine its merits. However, this occasionally backfires and your views are actually validated.
This was recently the case as I came across an article on Roger Ibbotson in the December 26, 2005 Fortune Magazine Investor’s Guide 2006 (p. 64). I WAS ASTONISHED TO READ, THAT ROGER IBBOTSON HAS ADJUSTED HIS LONG-TERM MARKET RETURN EXPECTATIONS DOWNWARD TO 9.27% FROM 10.3%.
This is a significant event and I’m amazed that it didn’t headline the front page of the Wall Street Journal. His estimation of expected market returns coupled with efficient market theory, governs nearly every calculation made by Pension actuaries, Investment Advisors and Retirement Planners.
I have contented for quite some time that a 10+% expected return from the broad stock market is ludicrous. I continued reading the article only to discover that he is downgrading his expectations for the exact same reason that I and many others have been preaching for some time – The stock market is expensive!
For those who may not know, Roger Ibbotson and a business school chum conducted a landmark study in 1974 that claimed the Dow would hit 10,000 by 2000 and a stock market investor could expect to earn approximately 10% in the market over the long haul. The starting point for Ibbotson’s landmark study was 1925.
The P/E ratio for US stocks in 1925 was around 10 and the average P/E for the market between 1925 and 2005 has been in the 14 to 15 range. Today, the stock market’s P/E ratio is around 20. (It’s somewhere between 18 and 21 depending on who you ask and what index you’re using.) In the article, Ibbotson admits that P/E expansion is responsible for a portion of the historic market returns and that we cannot expect P/E expansion to continue, therefore you have to discount expected returns accordingly.
The article reads as follows:
[Ibbotson] takes the 10.31% annual return on stocks from 1925 through the present and strips out the tripling of the markets price/earnings ratio that’s occurred since then. “We think of that as a windfall that you shouldn’t get again,” he says. The drivers of stock returns that remain are dividends, earnings growth and inflation. (emphasis mine)
It’s estimated by analysts that P/E expansion accounts for approximately 1% of the historic returns of the market, therefore, Ibbotson and others (including myself) discount future return expectations by 1% (10.3 – 1 = 9.3).
I agree with Ibbotson on P/E expansion, but I have to contend with another component of his calculation. The article goes on to say that Ibbotson is assuming that dividend history will repeat itself. WHAT! He admits that the market is significantly more expensive than it’s historic average, yet he’s suggesting that a stock market investor should expect to earn the market’s historic average dividend yield. It doesn’t work that way with any other financial instrument, why should it work that way with stocks.
The average dividend yield during Ibbotson’s study (1925-2005) was 4.23% and that’s the figure he uses in making his assumptions. Currently, the average dividend yield is in the 2% range (again, it depends on the index you’re looking at).
It’s not tough to calculate that 2% is about half of 4.23%. It certainly makes sense that if the market is twice as expensive today as it was in 1925 (P/E – 20 vs. 10), the dividend yield should be half as much – which it is
So, Ibbotson’s math doesn’t add up. If Ibbotson is willing to admit that P/E expansion has contributed to market returns then he must also admit that either a) P/E’s must contract in order for the dividend yield to return to it’s historic average or b) we can only expect a fraction of the dividend yield that the market has historically returned.
Either scenario calls for him to further adjust his expectations to the downside. In my opinion, it will be a combination of both. We should not count on an average dividend yield of 4.23% and, if we use history as our guide, P/E’s will contract.
In conclusion, an investor in a diversified US stock portfolio should not expect returns in excess of 6-7% over the next decade. Below average dividend yields and P/E contraction will take their toll on the broad US stock market. Over the next 70-year stretch (the same time horizon as Ibbotson’s study), the market may prove to be as profitable as Ibbotson suggests, unfortunately for me and my clients, we don’t have a 70-year investment time horizon.
Matt
Here is a link that complements this post.
http://www.legend-financial.com/content/ourviews_legend2.asp?SPID=19096&LinkID=32554&Title=Articles%20Online%20-%20Retire
