My clients and any regular reader of this blog know I am not in the business of making predictions about the future. Trying to time the market or pick individual stocks has been proven to be a losing strategy. We must, rather, try to predict relative future returns for various asset classes in order to do any sort of planning. The most common way for investors and advisors to predict future returns is to use historical returns. The logic is that over a long-term period, asset classes will behave much like they have for the last 100 years. Many recent studies have looked at the historical returns of stocks and bonds and how they have done during certain time periods. The results don’t look pretty for the future of these asset classes. Today we will look at stocks to see what the research says about the future returns of the stock market.

The Two Predictors

Many metrics have been studied to predict the future return of stocks, but today I will focus on two that I believe hold the most predictive power. The first one uses the Capital Asset Pricing Model (CAPM). At a high level, CAPM defines the return of the stock market as the risk-free rate of return (or one-month treasury bills) plus some sort of premium for taking on the risk of investing in stocks – the equity risk premium (ERP). Over the period from 1927 to 2012 the ERP has been just shy of 8%. Adding the risk-free rate, you get an average rate of return of about 11% for the US stock market (that’s the average annual return, not adjusted for compounding over time). Today the risk-free rate is about zero. When researchers looked back through the historical data they confirmed that when the risk-free rate is low, the total return of the stock market performed below average. If we assume that the ERP will stay at about 8%, the total return of the stock market would be about 3% less than it has been historically.

The second predictor of future stock returns involves the fundamental valuation of stocks (e.g. PE multiple) to predict the size of the ERP. For example, let’s say a company has a profit of $1,000 for the year. This company has 100 shares of stocks outstanding. Each share represents earnings of $10, also known as earnings per share or EPS. If you can buy this company’s stock for $200 a share in the market it is trading for 20x its earnings per share ($200/$10). We would say this company has a PE multiple of 20x. The long-term PE multiple of the stock market has been about 15x, which is pretty close to where it is today. The S&P 500 is about 1500 and the earnings of the underlying 500 companies is about 100. At first glance it looks like we are sitting at about normal valuation levels; however, there is a better predictor for future stock returns than looking at current valuations. It is known as “PE 10.” What PE 10 does is take the last 10 years of earnings for the S&P 500 and adjusts them into today’s dollars. Then it takes the average of these ten years and divides them by today’s price. The reason for going back 10 years is that it tries to capture a whole business cycle – EPS is relatively strong during the expansion in the economy and weak during a contraction. Historically, the average of PE 10 is about 15x, but today we sit at a much higher level of about 22x. When researchers looked back at the historical data they confirmed that when PE 10 was above its historical average, the ERP underperformed its historical average.

Putting It Together

When you combine the two predictors of future stock returns, it doesn’t paint a rosy picture of the future. If the risk-free rate is zero and PE 10 implies that the ERP will be closer to 6% instead of 8%, then the real return of stocks (adjusted for a normal inflation rate) could be 3% to 3.5% compounded return.

So, should you avoid stocks for the near term? As I mentioned earlier in this post, trying to time the market is a losing strategy. Equity has a place in almost everyone’s portfolio, and the proper allocation of equity is determined by a client’s risk profile and retirement objectives. While the commonly used predictors outlined above do not paint the best picture for stocks in the near term, fundamentals do and can change rapidly. For example, from 2003 to 2004, the earnings of the S&P 500 companies increased 75% from 36 to 63! This means that if the stock market traded at the same PE ratio in 2003 and 2004, it would have increased by 75%.