TIME TO PLAY MARKET strategist. Trying to figure out what sort of U.S. stock returns we can expect over the next 10 years? Nobody knows for sure, of course. But we can at least think about it in a reasonably logical way—by using what some folks call the Bogle method.
What’s that? In a 1991 article for the Journal of Portfolio Management, Vanguard Group founder John Bogle—who died in January 2019—laid out a relatively straightforward method for estimating stock returns. He subsequently revisited the idea a number of times, including in his book Common Sense on Mutual Funds. Here’s what the Bogle method tells us about today’s expected stock returns:
Dividends. This is the one component of future returns that’s known for sure. For buyers of the S&P 500 today, the starting dividend yield is some 1.3%, which is very low by historical standards. Over the past 50 years, the S&P 500’s yield has averaged 2.8%.
Earnings. To the dividend yield, Bogle would add expected earnings growth. Assuming 2021’s corporate profits come in as expected, the S&P 500 companies will have notched average annual growth in earnings per share of 7.3% over the past five decades, or 3.3% a year after adjusting for inflation.
I’m inclined to assume future earnings growth will be similar, but there are no guarantees. Even over decade-long stretches, earnings growth has been all over the map. The S&P 500’s earnings per share grew an inflation-adjusted 2.4% a year in the 1970s, fell 0.7% a year in the 1980s, grew 4.7% in the 1990s, slid 1.9% in the 2000s and soared 8.7% in the 2010s.
I was surprised by this variability. Over the past 50 years, there’s never been a single year when real (inflation-adjusted) GDP grew by 8.7%, let alone notching that rate for an entire decade. Similarly, in the 2000s, when earnings per share shrank by 1.9% a year, after adjusting for inflation, there was only one year when real GDP was negative.
Still, over the past five decades, real GDP grew 2.7% a year, similar to the 3.3% growth rate in inflation-adjusted earnings per share. There may be a short-term disconnect between the two because, say, a recession causes a big hit to reported corporate profits, but GDP and corporate earnings should roughly track each other over the long haul.
Based on the difference in yield between 10-year Treasury notes and 10-year inflation-indexed Treasurys, bond investors expect 2.5% annual inflation over the next decade. If we assume earnings per share grow 3.3 percentage points faster, we’re looking at 5.8% nominal growth in earnings. Add the 1.3% dividend yield, and that puts us at 7.1%.
This is what Jack Bogle called the stock market’s investment return. But is this what investors will get? That brings us to the Bogle method’s third factor.
Speculation. For investors to earn 7.1% a year from the S&P 500 over the next decade, the S&P 500 stocks would need to finish the 10-year period with the same price-earnings (P/E) ratio that they collectively have today.
Suppose the S&P 500 ends the year at 4700, close to Friday’s close. That means we’d be at a P/E ratio of roughly 25, assuming reported earnings for 2021 come in as expected. (A nerdy aside: At year-end, the S&P 500’s P/E will appear higher because, at that juncture, companies won’t yet have reported their 2021 earnings.)
Will the S&P 500 be at a P/E of 25 at year-end 2031? Your guess is as good as mine. Consider the range of possibilities:
Feeling queasy about the stock market’s prospects? Let me toss in even more uncertainty. Over the past 50 years, corporate earnings per share have benefited from widening profit margins, declining corporate tax rates and an end to dilution. Profit margins could narrow and corporate tax rates could rise, hurting earnings growth over the decade ahead. On the other hand, it seems dilution, which is caused by companies issuing ever more shares, is no longer a big issue, thanks to stock buybacks. Those buybacks may ensure inflation-adjusted earnings per share grow faster than the 3.3% I assumed above.
Where does all this leave us? I think we can draw two key conclusions. First, the Bogle method suggests we should ratchet back our return expectations for the next 10 years. It seems unlikely that the S&P 500 will notch 10% a year, and it could return far less. That’s the bad news.
The good news: Even if U.S. stock returns are grim, investors should still make more than they would with bonds. Yes, the ride for stocks will be rougher than that for bonds. But that rougher ride should be rewarded—even if it isn’t richly rewarded.