Past Perfect

Jonathan Clements

OVER THE 50 YEARS through year-end 2016, the per-share profits of the S&P 500 companies rose a cumulative 1,604%, equal to 5.8% a year, while inflation ran at 4.1%. If share prices had climbed in lockstep with corporate earnings, $1,000 invested at year-end 1966 would have been worth some $17,000 at year-end 2016. On top of that price appreciation, investors would also have collected dividends.

But in fact, over this 50-year stretch, investors fared far better. The share prices of the S&P 500 companies rose a cumulative 2,662%, equal to 6.9% a year, enough to turn $1,000 into $27,600. Result: Investors ended up 62% richer.

Puzzled? There’s no great mystery here. Over this 50-year stretch, the S&P 500 companies went from trading at 14.7 times corporate profits to 23.8 times earnings—a 62% increase in valuations.

What if you add in dividends? The dividend yield on the S&P 500 stocks was 3.5% at the beginning of the period and 2% at the end. Those modest numbers might make dividends seem like a minor issue. But in fact, thanks to compounding, dividends added enormously to investor wealth. Over the 50 years, the S&P 500’s total return—share price appreciation plus dividends—was 12,559%, or 10.2% a year, turning our $1,000 into $126,600.

Now suppose that, at year-end 2016, the S&P 500’s price-earnings (P/E) ratio plunged back to its year-end 1966 level. Investors would have been left with $78,200—still an impressive sum. Indeed, eliminating the gain from the market’s rising P/E reduced the market’s return by a mere 1.1 percentage points a year.

Telling stories. You can view these figures as confirmation of standard Wall Street wisdom: If you’re a long-term investor, you shouldn’t fret too much about current valuations, because changes in valuations are far less important to long-run returns than earnings growth and dividends.

Seem reasonable? Before we accept this comforting investment story, let’s ponder the next 50 years for U.S. stocks. Thanks to the aging of America and the accompanying slow growth in the workforce, the current century’s real economic growth has been sluggish, averaging 1.9% a year. That’s likely to continue.

“If you follow a high-cost strategy and are careless about taxes, you could throw away your entire after-inflation gain.”

Let’s say we get 2% real economic growth in the decades ahead. Factor in 2% inflation and we’d be at 4% nominal growth. Meanwhile, dividends are currently 2%. Add that 2% dividend yield to the economy’s projected 4% annual growth, and we’re looking at 6% stock returns. This assumes corporate earnings expand at the same rate as the economy and there’s no change in valuations. At 6% a year, $1,000 would turn into $18,400 after 50 years.

But what if P/Es don’t stay the same—and instead drop from 23.8 times earnings to 14.7, reversing the gains of the past 50 years? Over the next 50 years, $1,000 would grow to just $11,400, for a return of 5% a year.

Learning lessons. On the one hand, this appears to confirm Wall Street wisdom: Our assumed collapse in valuations knocked just one percentage point a year off returns. Earnings growth and dividends were able to overcome that hit, so stock investing was still a profitable endeavor.

On the other hand, we are talking about a 5% return. That’s thin gruel. Our projected $11,400 is a far cry from the $126,600 that investors collected over the past 50 years. To be sure, the gap narrows if we factor in inflation. The next 50 years’ $11,400 would be reduced to some $4,200 if we adjust for our assumed 2% inflation rate, while the past 50 years’ $126,600 becomes $17,000 if we adjust for the actual 4.1% inflation.

Still, investors are potentially ending up with just a quarter of the wealth they would have amassed over the past 50 years. What should readers make of all this? Here are four implications:

  • Our 50-year projection is built on three key numbers: the starting dividend yield, economic growth and a collapse in valuations. The starting dividend yield is known—and it is, alas, modest by historical standards. The economic growth rate is a guess, but not an absurd one, given demographic trends. The collapse in P/E ratios is, of course, pure speculation. I doubt we’ll see anything that severe, though I wouldn’t be surprised to see some drop from today’s lofty level.
  • After backing out inflation, we’re looking at a total return that’s maybe 3% or 4% a year. If you buy low-cost index funds and pay careful attention to taxes, you should pocket most of that return. If you follow a high-cost strategy and are careless about taxes, you could throw away your entire after-inflation gain.
  • We have focused here on U.S. stocks. The outlook for foreign stocks—and especially emerging markets—is brighter, I believe. If you have a healthy allocation to foreign stocks, you might earn more than the 5% or 6% a year we’ve been discussing.
  • A potential collapse in valuations is a much bigger headache for those who have a large lump sum to invest or who are retired. For those still in the workforce and regularly adding new savings to their stock portfolio, a sharp drop in valuations would be a bonanza—provided they don’t panic and sell, but rather stay the course and continue to add to their portfolio at the lower valuations.

Children? Just Say Maybe

We know a lot about happiness. Marriage, time spent socializing, religious beliefs and a high income relative to others can all help, while commuting, divorce, unemployment and ill-health can hurt.

But a big question remains unanswered: What impact do kids have? Children may be a blessing—but it seems they’re a mixed blessing. Here are some of the research findings:

  • Happier people tend to have children—but having children often reduces their happiness.
  • In wealthier countries, the hit to happiness is greatest among those who become parents before age 30. But if you’re over age 30 and affluent, having kids can help happiness.
  • U.S. women report that looking after their children is slightly less enjoyable than doing housework.
  • The birth of a child boosts both parents’ reported satisfaction with their lives. But that boost dissipates over the child’s first few years and then turns into a drag on parental happiness.
  • Those living with children are more likely to report feeling anger and stress.
  • Young children hurt mental wellbeing, but having adult children can help. In other words, if you goal is greater happiness, children may be a bad short-term investment—but they pay dividends over the long haul.

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