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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.
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:
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Jonathan, I liked this article so much 7 years ago that I sent it to my family to start a conversation. One thing I took away was that despite the “thin gruel” of a prospect of 5-6% growth for stocks, bonds were offering even thinner gruel leading me to conclude that TINA to stocks.
It appears that P/E multiples expanded since then. International did not do better. I’d be interested in your thoughts about what transpired since you authored this.
For me, the two big surprises over the past decade have been how low bond yields got, which drove P/E ratios higher, and the continued extraordinary earnings growth at big tech companies. The lesson: Don’t assume you know anything about the future, at least when it comes to the stock market!