Total Stock Returns = Fundamental + Speculative Returns

Another theory of predicting future stock market returns states that there are three main components to long-term stock market performance. Amongst many others, I learned this from authors and investors Jack Bogle and William Bernstein.

Part 1: Dividend Yield
If your stock distributes 2% in dividends each year, then you will have a 2% contribution towards of return. This is what dividend investors love to see coming in each quarter, and is relatively easy to track for a large group of companies. Here it is over time for the S&P 500, courtesy of Multpl.com:

Part 2: Earnings Growth
If earnings stay constant, then all other things equal, one would expect the share price of your company to stay constant as well. If the earnings grow by 5% every year, then your share price will grow by 5% per year. Thus, earnings growth rate is a vital component of total return.

If your portfolio was all of the stocks traded in the United States, like that of a broad-based index fund, this would create a connection between the growth rate of the nation’s Gross Domestic Product and the earnings growth rates of all US companies. In other words, the fundamental return is based on GDP growth. In turn, the GDP growth rate is connected to population growth and productivity per person.

These two parts added to together are coined the fundamental return:

Some bad news: Now, from 1950-2000, fundamental returns were 10%: 4% dividend yield and a 6% earnings growth rate. These days, the S&P 500 has a dividend yield of only about 2%. Earnings growth rate estimates are subject to debate, but they hover around 5-6%.

Part 3: Changes in P/E Ratio
The price-to-earnings (P/E) ratio is the price per share divided by earnings per share. In other words, it is how much investors are willing to pay for each unit of earnings. If they are willing to pay 20 times annual earnings, the share price of the stock will be twice as high as if they only paid 10 times earnings. This part is denoted the speculative return, as it has changed throughout history. Here it is again for the S&P 500:

In 1950, the P/E ratio was less than 10. As of right now in mid-2010, it is 20. It is very unlikely that this more than doubling of price-per-share will happen again, with the historical average being around 15. (During the dot-com bubble, the P/E ratio was over 40. In 2008, it was over 25.) This will lead to a zero, and quite possible negative, future speculative return!

Summary

Source: Little Book of Common Sense Investing, Exhibit 7.1

When predicting future returns, you have to look at all the sources of those expected returns. Fundamental return is still a solid reason why stock prices will go up on the long-term, especially if you are not investing only in one country or economy. Some people call it a belief in capitalism, that economic growth will continue and GDP will continue to increase. I simply believe in the passion and motivation of all the people out there, from Sweden to China to Brazil. However, there is good evidence that you might not be getting 10% historical returns due to P/E ratio contraction.

In a recent column, Larry Swedroe shares that the forecasts that he has read are predicting a 5% total annual growth in earnings and 2% dividends for a total return of 7% (similar to above). Inflation is predicted at 2.5%. However, he points out the current minimal-risk return is pretty low as well, so you need consider the big picture:

The bottom line is that while the expected nominal return to stocks is lower than the historical return, so is the expected return to Treasury bonds. You should decide if the expected risk premium for stocks is sufficient given your unique ability, willingness and need to take risk.