For the past 31 years , a conventionally-diversified portfolio consisting of 60% stocks and 40% bonds has provided investors with satisfying returns of +10.80% annually. This was the result of both stocks and bonds advancing strongly throughout that period. Better yet, stocks and bonds complimented each other nicely. When stocks returned +19.35% annually from the market low in 1982 to its peak in August 2000, bonds lagged somewhat (although still returning a substantial +10.34% annually). But in the period from the 2000 market peak to the 2009 market low, while stocks declined a sharp -43.51%, bonds balanced that with a strong +61.78% rally. More recently, both stocks and bonds have advanced, with the 60-40 portfolio gaining an annualized +15.36% from the market low in March 2009 to May 31, 2013.
The past 31 years was an unprecedented period for a 60-40 portfolio; one that wasn’t seen prior. In fact, as I wrote in my best-selling book, Jackass Investing: Don’t do it. Profit from it., “all of the real stock market returns over the past 111 years can be attributed to just an 18 year period – the great bull market that began in August 1982 and ended in August 2000. Without those years the real, inflation-adjusted return of stocks, without reinvesting dividends, was negative.”
Unfortunately for investors, the 60-40 results of the past 30 years aren’t likely to repeat in the near future. Here’s why not.
Return drivers for U.S. equities
There’s an ethos among equity investors that stocks provide an intrinsic return. This ethos is rooted in a depth of academic research that identifies an equity “risk premium” as the source of stock market returns. The equity risk premium is the “theory” that equities are destined to produce greater returns than less risky investments such as corporate bonds, simply because they ARE riskier.
In fact, the “research” supporting the equity risk premium is actually not research at all but merely an observation – an observation that over the past couple of centuries stock returns outperformed bonds. Then a postulate, the risk premium, was created to support that observation, which in turn was “proven” by the observed data. As you could likely surmise from the obvious circularity of the postulate and proof, this is wrong. The risk of investing in stocks has nothing at all to do with their returns. As I show in Jackass Investing, stock market returns are driven by three primary “return drivers”.
In the book’s first chapter I show how over the long term stock market returns are dominated by corporate earnings growth, and in the short-term (less than 20 years) by the multiplier (the “price/earnings” or “P/E” ratio) people are willing to pay for those earnings. The chart displaying this is reproduced here :
Effect of Earnings Growth and People’s Enthusiasm on Stock Prices
In the second chapter I display the fact that historically, dividends have provided 48% of the total return from U.S. equity investing over the period 1900 - 2010 . (In most of the studies presented in my book and in this article, I use the S&P 500 total return index which includes dividends. The ETF that generally corresponds to the price and yield performance of the S&P 500 is SPY).
Knowing this, these were the three dominant return drivers that contributed to the stock market’s +11.88% annualized return over the past 31 years:
1. 6.16% of the annual return was driven by the average annual profit growth of 6.16% 2. 3.19% of the annual return was the result of the increase in the P/E ratio from 10 in 1982 to more than 23 at the end of 2012 (using the cyclically-adjusted P/E (“CAPE”) presented by Robert Shiller in his book Irrational Exuberance ) 3. 2.53% of the annual return was due to the dividend rate starting the period at an historically high 6.24% in 1982 and averaging 2.53% throughout the period Going forward, if the P/E ratio reverts to its long-term average of 16.4, corporate profits grow at their historical average of +4.70%, and dividends increase at the same rate as corporate profits (and the dividend payout ratio increases to its long-term average), stocks will appreciate at just 7.05% per year over the next decade. Here’s the arithmetic.
About the Author:
Michael Dever is the CEO and Director of Research for Brandywine Asset Management, an investment firm he founded in 1982. He has been a professional investor/trader since 1979 and has experience in stocks, managed futures, commodities, mutual fund timing, market neutral equity, and long/short equity. He is also the author of "Jackass Investing: Don’t do it. Profit from it.”, an Amazon Kindle #1 best-seller in the following “investment” categories: Commodities, Futures, and Mutual Funds.
