Posted by on Dec 27, 2015 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  8:23 am ET  Dec. 24, 2015

‘Tis the season to make guesses.

You might think that to predict stock or bond returns like a Wall Street strategist at year end, you need to mutter obscure incantations over a computer spewing out long equations bristling with Greek letters. But what if simplicity beats complexity?

Twenty-five years ago, John C. Bogle, founder of Vanguard Group, the giant investment firm, began publishing studies of stock and bond performance, seeking to determine the “sources of return” that have driven their results.

Mr. Bogle updates his findings in an article in the latest issue of the Journal of Portfolio Management. Combing through returns all the way back to 1915, he found that you can explain the past returns on stocks — and predict their future returns with decent accuracy — by taking only three factors into account.

At first, that sounds so childishly simple it has to be wrong. But researchers in many fields have found that extremely basic formulas are often superior at making predictions about complicated systems.

The first of Mr. Bogle’s three elements is the starting yield, or annual dividends divided by stock price, currently about 2.2%. Second is earnings growth, which historically has averaged about 4.7%. Together those sources constitute what he calls the “investment return,” because they are based on the cash that companies generate.

Third is the “speculative return,” or any change in the mob psychology of how much investors want to pay for stocks. The S&P 500 is priced nowadays at about $23 per $1 of earnings per share, or a price/earnings ratio of nearly 23.

If that ratio rose to 25 over the coming decade, that would be roughly a 10% increase — boosting stock returns by about one percentage point annually. On the other hand, if the P/E fell to 20, that decline of more than 10% from today’s level would lower the next decade’s returns by about one percentage point per year.

That 2.2% dividend yield, plus the 4.7% earnings-growth rate, equals a smidgen under 7%. If market valuations rise one percentage point annually, that would take average returns up to about 8%; if they fall the same amount, total returns would drop to about 6%.

As for bonds, Mr. Bogle has found that essentially all you need to know is the yield to maturity, or the implied interest rate that makes the present value of all of a bond’s future cash flows equal to its current market price. Analyzing 10-year periods back to 1906, he found that at least 90% of the subsequent return on bonds could be explained by their initial yields; capital gains and losses barely registered. So, with the Barclays U.S. Aggregate index of government and corporate bonds yielding 2.6%, that’s the baseline expectation.

None of these figures count inflation, which the Federal Reserve has targeted at 2% annually. Subtract that to account for loss of purchasing power, and stocks look likely to return an average of about 5% annually over time; bonds, less than 1%.

Note that these are expectations for the coming decade, not the next year — which is notoriously hard to predict.

By so clearly decomposing expected return into the factors that drive it, Mr. Bogle provides a model anyone can adapt. “If you don’t like my numbers [other than dividend yield],” he says, “you can put in your own.”

Do you think technology will enable future earnings to grow faster than in the past, or that investors might be willing to pay much more for those earnings than they used to? Do you instead believe the future will be worse? Then ratchet the earnings-growth rate and P/E contribution up or down accordingly.

You can apply the same principles to any financial asset. Take commodities. Historically, a diversified basket of such assets as oil, gold and soybeans has had four main sources of return, says Ryan Larson of Research Affiliates, a firm in Newport Beach, Calif., whose investment strategies are used to manage about $154 billion.

One comes from renewing commodity contracts over time — the “roll return.” Another is the interest earned on collateral to finance the purchase of commodities. Third, market prices go up or down. Finally, a commodities portfolio manager can sell some of whatever has gone up the most and use the proceeds to buy some of whatever has gone down the most — a technique called rebalancing.

The roll return on many commodities has gone negative, while the interest on collateral is nil. Research Affiliates expects commodities to return 3.6% annually over the next decade, after inflation. But nearly all of that assumption, as Mr. Larson concedes, depends on rebalancing and changes in market price; it gets no tailwind from the investment factors of roll or collateral return. As of now, you will need mob psychology on your side from now on in order to make good money in commodities.

As 2016 approaches, ignore Wall Street’s elaborate guesswork. Sharpen your own pencil, think long-term and keep it simple.

UPDATE: Yield to maturity is the implied interest rate that makes the present value of all of a bond’s future cash flows equal to the bond’s current market price. An earlier version of this column incorrectly defined yield to maturity as interest income divided by market price.


Source: The Wall Street Journal