Stock Return Outlook: Not-So-Great Expectations

    by Steve Norwitz

    In the unprecedented stock market boom of the late 1990s, equity investors became accustomed to double-digit annual returns as the Standard & Poor’s 500 index reeled off five straight years of gains exceeding 20%.

    That bubble burst, however, and the S&P 500 produced a –4.7% annualized return from the end of 1999 through July 2004 despite the vigorous rebound in 2003.

    So, what should investors realistically expect for equity returns over the next five to 10 years?

    Given the recent level of market valuation and the current outlook for earnings and dividend growth, many advisors encourage equity investors to have moderate expectations with returns possibly averaging in the mid- to high single digits over the next several years. This would be considerably below the 12% average annualized return on the S&P 500 since 1950.

    Over the long term, market returns tend to approximate the dividend yield plus the rate of growth in earnings and dividends. However, there are times when equity market valuations as measured by the price-earnings ratio expand, such as much of the period from 1982 to 2000. There are also periods when valuations contract—for instance, the recent bear market saw a significant compression of price-earnings ratios.

    So, the question for the investor now is, “What’s in store for the market’s valuation?”

    History suggests that after periods of substantial valuation expansion there can be periods of contraction, which would make it appropriate for investors to have more moderate return expectations.

    TABLE 1. The Anatomy of Stock Market Returns: 1950-2004
    Period S&P 500
    P/E* at:
    Total Return From: Annualized
    Yield at:
    Rise/Fall in
    (16 yrs)
    7.2 17.8 5.2 4.8 6.1 16.1 2.22 4.47
    (16 yrs)
    17.8 8 7 4.1 -5.2 5.9 4.47 14.09
    (19 yrs)
    8.0 26.4 6.4 3.5 6.9 16.8 14.09 5.57
    (as of 11/30)
    26.4 20.6 3.8 1.8 -6.9 -1.3 5.57 4.36
    7.2 20.6 6 4 2 12 2.22 4.36

    *Earnings growth based on 12-month trailing reported earnings.

    **Assumes reinvestment of dividends.

    Over the long run, stock returns tend to reflect growth of earnings and dividends, but there are often extended cycles where valuations, as measured by the price-earnings ratio (the value investors place on those earnings), can significantly enhance or undermine returns. This table and Figures 1 and 2 show some extended periods of P/E multiple expansion or contraction as well as earnings and dividend growth since 1950. The annualized return of the S&P 500 is comprised of these three variables. So, from 1966-1981, earnings outpaced equity prices because of the collapse in valuations over the period, undermining stock returns. But in the great bull market from 1982-2000, stock prices grew much faster than earnings as the P/E multiple on the S&P 500 more than tripled, accounting for 41% of the market’s total return over that time.

    Source: T. Rowe Price Associates, Inc. Data compiled by The Leuthold Group.

    Analyzing Equity Returns

    Table 1, which shows the anatomy of equity returns (composed of earnings growth, reinvested dividends, and changes in market valuations) over three different long-term periods since 1950, helps illustrate why investors should have relatively modest expectations.

    From 1950 to 1965, for example, price-earnings multiples expanded significantly, reflecting prosperity after World War II. During this time, the stock market achieved an extraordinary annualized return of 16.1%. Corporate earnings grew at a 5.2% annual rate, and the value of reinvested dividends contributed 4.8%; combined, these two fundamental drivers of stock returns produced an annualized gain of 10%. Investors’ optimism for equity investing, though, pushed the price-earnings multiple (the amount investors are willing to pay for each $1 of earnings per share) from 7.2 at the start of the period to 17.8 at the end (based on 12-month reported earnings). This valuation boost added 6.1 percentage points to equity returns on top of the gains derived from growth in earnings and the value of reinvested dividends. As a result, stock prices substantially outpaced earnings as the price-earnings multiple more than doubled.

    In contrast to this rewarding 16-year period, the next 16 years were characterized by sharply rising inflation and interest rates, energy shortages, and the divisive Vietnam War—not a great recipe for investor optimism. From 1966 to 1981, earnings grew at a favorable 7.0% rate and reinvested dividends contributed 4.1% to average annual returns. However, investor concerns about the future caused a steep contraction in valuation (see Figure 1). The price-earnings multiple declined from 17.8 to 8.0. This contraction reduced the average gain by 5.2 percentage points, resulting in a modest average annual return of 5.9%. As seen in the figure, stock prices significantly lagged earnings because of price-earnings compression.

    Figure 1.
    Stock Earnings Outpace
    Prices as P/E Shrinks
    (12/31/65 to 12/31/81)

    Coming off such a low base for valuations, and with interest rates and inflation falling sharply from the double-digit peaks marking the end of the prior period, the stage was set for another acceleration in equity returns, culminating in the speculative fervor of the late 1990s (Figure 2). Over these 19 years, the price-earnings multiple surged from 8.0 to 26.4, earnings grew at a 6.4% annual rate, and reinvested dividends contributed at a 3.5% rate. The S&P 500’s annualized return was 16.8%, with valuation expansion accounting for 6.9% (or 41%) of the gain and stock prices outpacing earnings.

    Figure 2.
    Stock Prices Outpace
    Earnings as P/E Surges
    (12/31/81 to 12/31/00)

    Overall, the 12.0% annualized return of the S&P 500 since 1950 through November 2004 has been mainly driven by growth in earnings and reinvested dividends, with the valuation change accounting for only 2.0 percentage points (or 16%) of the total return. However, as you can see from Table 1, the market can experience long periods of expansion or contraction in the price-earnings multiple that can enhance or undermine gains based on fundamentals.

    Table 1 also indicates that trends in interest rates and inflation can significantly influence the valuations investors place on stocks. One major reason for this is that the more interest rates rise, the less future cash flows of a company are worth in today’s dollars. As a result, higher interest rates tend to depress equity valuations. In addition, fixed-income investments become more attractive relative to stocks as rates rise.

    Table 1 indicates the 10-year Treasury yield at the start and end of each period. For example, in the period of price-earnings multiple contraction from 1966 to 1981, the 10-year Treasury yield rose from about 4.5% at the start to 14.1% at the end. During the following period of price-earnings multiple expansion, the yield declined to about 5.6%. In recent years interest rates have fallen further, with the 10-year Treasury reaching a low of 3.68% in March 2004, but stock multiples also retreated as the market corrected from substantially overvalued levels prevailing at its peak in 2000.

    Where Do We Go From Here?

    Looking ahead, equity returns will continue to depend on prospects for earnings, dividends and valuations. Despite strong earnings growth recently (four consecutive quarters of 20% year-over-year gains through the second quarter of 2004), some observers expect fairly modest growth in coming years—perhaps less than the long-term average of about 6%.

    In addition, profit margins are at the highest level in several decades and the effective corporate tax rate is the lowest since World War II, so there could be more pressure on margins and therefore profits if economic growth slows or tax rates rise.

    On the dividend front, meanwhile, the reduction in the tax rate on dividend income to 15% has encouraged hundreds of companies to increase dividends and many others to initiate them. Dividends are likely to become a more important component of equity returns than in recent years, even though the current dividend yield on the S&P 500 was recently only about 1.7%.

    What About Valuations?

    What happens with equity valuations, of course, is anyone’s guess. In early August 2004, the S&P 500 had a price-earnings ratio of 16.8 based on estimated earnings for this year, which was well below the levels reached at the peak of the last bull market, but still above the historical average of about 15.0. Market valuations may be unlikely to sustain a significant expansion from current levels, particularly if interest rates and inflation, which are still moderate, increase more than expected.

    Figure 3.
    S&P 500 Median
    10-Year Annualized
    Return at Various
    Valuation* Levels:
    1950 to 2003

    Historically, equity returns have been relatively moderate over 10-year periods following valuation levels comparable to those seen recently. The Leuthold Group, a market research firm, tracks performance from various levels of valuation based on “normalized” earnings (reported earnings growth over a five-year period averaged to smooth cyclical distortions), illustrated in Figure 3.

    As of September 30, 2004, the price-earnings ratio of the S&P 500 on this basis was 21.5, approaching the “expensive” end of the historical range. From comparable valuation levels, based on performance since 1950, the median annualized return over the subsequent 10-year period was 8.8%, as seen in Figure 3. (The median means half the periods had returns higher than this and half had lower.)

    Other Considerations

    Figure 4.
    Annualized S&P 500
    Returns for Rolling
    10-Year Periods
    Since 1950

    Given current valuation levels and reasonable expectations for earnings and dividend growth, investors can probably expect high single-digit equity returns. But investors should remember that averages can be deceiving. Even if you expect equity returns to average 7% to 9% over the next five to 10 years, you may get a significant portion of the returns in a very short period.

    Even over 10-year investment periods, the annualized return can fluctuate dramatically, as reflected in Figure 4. The average annual return for all rolling 10-year periods since 1950 was 11.9%, but investors enjoyed gains much above that until the 2000–2002 bear market. The two most recent 10-year periods have generated an average annual return below that level (supporting the “regression to the mean” theory.)

    Another important caveat is that even if you have index returns that approximate high single-digit levels, performance of certain sectors or investment styles can vary substantially, providing opportunities for investors. Over the past few years, small- and mid-cap stocks have done much better than the S&P composite.

    While the stock market may perform better than expected in some years, investors are advised to maintain a well-diversified portfolio, take a long-term perspective, and be realistic regarding potential equity returns.

    Steve Norwitz is a vice president at T. Rowe Price and editor of the T. Rowe Price Report, published by T. Rowe Price Investment Services, an investment advisory firm that manages the T. Rowe Price family of mutual funds ( This article originally appeared in the Fall 2004 issue of the T. Rowe Price Report.

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