Set your clients up for a pleasant experience — by lowering their expectations.
When stocks are soaring, we should have mixed feelings if we’re rational, because higher prices likely mean lower future returns. But instead, it takes falling share prices to dampen expectations for returns. That’s what we have seen since August, when global markets started spluttering along with the Chinese economy.
The recent nervousness about future stock performance is actually good news. The fact is that stocks are highly unlikely to match their historical record of outpacing inflation by 7 percentage points a year. If your clients expect that sort of performance, they’ll save too little for their goals, spend too much in retirement, become unnerved when their expectations aren’t met — and find somebody to blame for all of this. That would be you.
My advice: Take the initiative and start telling clients that stocks might beat inflation by just 4 percentage points a year over the next decade. Here’s why stock returns are likely to be modest, plus one possible bright spot:
Pundits keep waiting for U.S. after-inflation economic growth to return to its 50-year average of almost 3% a year. It isn’t likely to happen anytime soon, for one simple reason: Young adults entering the workforce barely outnumber baby boomers who are retiring, so growth in the labor force has slowed to just 0.5% a year, far below the 50-year average of 1.5%.
That’s a big deal, because, historically, half of the economy’s growth has come from increasing the number of workers, while the other half has come from increasing productivity of those workers.
Without a surge in productivity or a huge increase in immigration, economic growth is likely to be tepid. In fact, in the 14 full calendar years since the end of 2000, it’s managed just 1.7% a year. Even the recovery from the 2008-09 recession has been notably muted, with the economy growing just 2.1% a year over the past five calendar years.
Slow economic growth is potentially bad news for corporate earnings. While company profits don’t rise in lockstep with the economy, you would expect the two to be roughly similar over the long run.
Yet that isn’t how things have panned out over the past 14 years. Since 2000, earnings per share for the S&P 500 companies have grown 3% a year, after adjusting for inflation, faster than the economy’s 1.7% growth rate. How did corporate America manage that? Starting in 2001, something remarkable happened to after-tax corporate profits: They rose to 10% of GDP from 4%, so they’re now well above the 50-year average of 6.5%. That growth has come at the expense of wages, which shrank as a percentage of GDP.
Perhaps profits won’t fall back to 6.5% of GDP. But we also can’t expect profits to snag an ever-greater greater share of GDP, and, indeed, this isn’t desirable. The resulting political firestorm probably wouldn’t be good for those of us who own stocks.
Historically, existing shareholders have seen their claim on total corporate profits slowly diluted, as new companies are launched and existing companies issue more shares. Due to this new share issuance, earnings (when calculated on a per-share basis) have tended to grow 2 percentage points a year more slowly than total corporate profits.
That brings us to a second remarkable development: Over the past decade, S&P 500 companies have bought back shares almost as rapidly as they have issued stock, so existing shareholders haven’t suffered much dilution.
That might seem like good news. But it’s more of a mixed blessing. Many share buybacks appear to be driven by a desire to offset the dilution caused by executives exercising their stock options. In other words, corporate earnings, which could have been paid out to shareholders as dividends or used to expand the business, have instead been used to support management’s hefty compensation packages.
In addition, because so much money has been devoted to buying back stock, there’s a suspicion that companies have been skimping on capital spending. That means companies may grow more slowly in the future — and, at some point, may have to play catch-up after years of neglect, and start spending a whole lot more on capital investment.
To pay for this, companies might stop buying back stock and might even issue new shares. Suddenly, existing shareholders may discover their stake in corporate America is being diluted faster than ever before.
U.S. stocks have been so expensive for so long that many investors have grown complacent about valuations. Take the S&P 500’s CAPE, or cyclically adjusted price-earnings ratio, which compares the market’s current level to average inflation-adjusted corporate profits for the past 10 years.
From 1946 to 1990, the S&P 500’s CAPE averaged less than 15. Since then, it’s averaged almost 26, despite two grueling bear markets. That suggests valuations are permanently higher; maybe investors shouldn’t worry about the stock market’s price-earnings ratio reverting to historic norms.
That doesn’t, however, mean investors shouldn’t fret about future performance. As with profit margins, we can’t expect price-earnings ratios to climb ever higher. Meanwhile, the past increase in the price-earnings multiple represents a one-time gain — and we can’t enjoy that gain again unless we have a massive bear market first.
If we look at corporate America and U.S. stocks in isolation, it’s hard to be cheery about the market’s outlook. But if we take a global view, there’s reason for greater optimism. Potentially, U.S. corporations could compensate for slow growth at home by expanding abroad. Potentially, foreign shares — which are valued more reasonably than U.S. stocks — could deliver higher returns.
Even so, I’m expecting my stock portfolio to deliver only 4 percentage points a year more than inflation. If you buy the S&P 500 stocks now, you get roughly a 2% dividend yield. What about share prices? I expect the U.S. economy to expand 2 percentage points a year faster than inflation. I’m hoping corporate earnings, and hence stock prices, will climb at a similar pace. Add the 2% dividend to the 2% after-inflation share price gain, and you get a 4% real total return.
Sure, there’s a risk that earnings per share might grow more slowly because existing shareholders see their stakes diluted. True, there’s a risk profit margins will contract and price-earnings ratios will fall. But my hope is that, even if this occurs, my portfolio will be saved by global markets.
Jonathan Clements, a Financial Planning columnist in New York, is a former personal finance columnist for The Wall Street Journal. He’s the author of Jonathan Clements Money Guide 2015 as well as the forthcoming How to Think About Money. He’s also former director of financial education at Citi Personal Wealth Management. Follow him on Twitter at @ClementsMoney.
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