Equity Returns – Optimistic arguments about longer-term profits to be made in US shares are “deeply flawed” as they’re based on double-counting and circular reasoning, Brett Arends argues on Marketwatch.
Future returns are extrapolated from past returns. But a dramatic upward re-rating of stocks was experienced in the past. It’s unlikely that can be repeated.
Back in the 1920s, investors typically paid about $13 for a basket of shares generating a dollar a year in net earnings. Today it would cost you twice as much to buy the same amount of earnings.
“Maybe shares really were undervalued before,” Arends says. “Maybe investors will always pay $26 or more in the future for each dollar of earnings. But to count such past gains in your future expectations is to engage in circular reasoning – or a wild set of assumptions. To get the same one-off gain in the future, stocks will have to go all the way up towards 50 times cyclical earnings.”
The second mistake is to ignore what’s happened to dividends, which in the past accounted for a big proportion of the total returns from shares. Until the early 1980s, the stock-market typically boasted a yield above 5 per cent. Today it’s less than half that. Every year your dividends are contributing much less to potential returns.
Investors may expect to get a little more back in the form of equity repurchases. “But they shouldn’t count on it,” Arends says. “Companies have a terrible record of buying back stocks at the wrong time.
“More importantly, while they buy back stock with one hand, they issue lots more to the [chief operating officer] and other favoured insiders with the other. The net effect is that overall share counts go down a lot less than you expect – and… may actually go up.”
What comes out of the wash? Predictable future average annual returns “drop about three percentage points.” Investors today “shouldn’t be expecting real returns of 6 per cent or 8 per cent, as they have seen at times in the past, but much more modest real returns of around 3 per cent.”
And that’s ignoring the most bearish spectre for stocks – that valuations could undergo “reversion to the mean” and fall back to what they were in the past, savaging capital values.
copyright: Martin Spring of OnTarget
