A Brighter Outlook for Stocks
Last year certainly wasn't one to write home about. But I think many prognosticators are too pessimistic about the stock market over the long term -- the next five to ten years. They're so down in the mouth, I believe, because they're overlooking something critical.
The mantra that I hear, often from otherwise savvy strategists, goes something like this: "Stocks, over most periods, can't be expected to return more than the growth in the economy, plus dividends. With U.S. gross domestic product increasing about 3% annually, and dividends about 2%, you can't expect stocks to return more than 5%. Make it 7% when you include 2% annual inflation."
Now, I'll buy one part of the experts' argument: We're not going to see a return of the stock markets of the 1980s and 1990s any time soon. Short-term interest rates dropped from 19% in 1981 to just over 4% at the end of last year. Short-term rates obviously can't fall another 15 percentage points. Similarly huge declines in inflation and long-term rates are also mathematically impossible. Because lower inflation and lower interest rates helped fuel the long bull market, it's unlikely that stocks will rise 15% or 20% annually in the future. Those kinds of returns are history.
But here's what the experts leave out: Dividends can rise substantially from current levels. Companies have already boosted payouts significantly -- partly because of the Bush tax cut on dividends, which will almost certainly be renewed, and partly because companies are awash in cash.
Just how much cash do companies have? A ton. Indeed, dividend payout ratios -- the percentage of after-tax profits companies pay to shareholders -- are at close to an all-time low. That's from Jeremy Siegel, a Kiplinger's columnist and a finance professor at the Wharton School.
Historically, dividend payout ratios for most companies have been about 60% to 70%, Siegel says. "Now it's only about 33%."
Whether companies choose to increase their dividends -- which many surely will -- or buy back more of their own stock, the net effect is the same for investors.
As Siegel points out, returns on stocks aren't dependent on overall corporate earnings growth, which, indeed, can't be much higher than GDP growth. They're dependent on corporate earnings per share. So if companies buy back shares with some of that excess cash, reducing the number of shares, we can expect higher returns from stocks.
There's no reason not to expect an annualized 10%-plus a year from stocks. That's what stocks have returned since 1926, according to Ibbotson Associates. And the price-earnings ratio of the SP 500 is a reasonable 16 based on 2006 analyst estimates. That's precisely what the average P/E of the SP has been historically.
The SP 500 returned 5% last year. But what's more interesting to me is the five-year return of the SP. The index has been essentially flat during those years.
In other words, we've had our bear market. The market sank 47% from March 2000 through October 2002, which ties with 1973-74 for the worst bear market since the Great Depression.
Pessimism is often the order of the day after bad markets. The bull market of the past several years, which is still intact, has hardly made a dent on anyone's consciousness. That, again, is a good sign.
The best, my friends, is yet to come.
Opinions expressed in this column are those of the author.