By Christopher Farrell Recently, I interviewed John Bogle, founder and chairman of Vanguard Group, on my public radio program. In the course of a wide-ranging conversation on everything from Corporate America's accounting scandals to mutual-fund governance, I asked the outspoken octogenarian financier for his forecast for stock market returns over the next decade.
He replied that a reasonable outlook for individual investors was a 4% to 9% average annual gain. Later in the program, while taking a listener's question, I offered my own assessment -- and it was a little more bearish. I chose a 4% to 6% return range.
These numbers sparked several e-mail protests, including this one from Ohio:
"I am quite puzzled and, in fact, alarmed by John Bogle's expectations for stock valuation growth over the next decade. Even more disconcerting is your own, lower prediction of 4%-6% growth over the foreseeable future. I'm curious as to why you think returns will be so low for such an extended period of time.... Over the past 75 years, equity appreciation has averaged about 11% annually. This is documented history.... Why would you expect the long-term future to underperform so drastically?"
BEHIND THE NUMBERS. The essence of investing is making decisions in the fog of uncertainty, and the murkiness is especially heavy at a time of upheaval like this. Still, an impressive array of evidence suggests that individual investors should dampen their return expectations, at least for the next 5 to 10 years. The trajectory of stock market returns is far more complicated than pictured by a casual glance at the upward wave of a graphic charting the nearly 11% average annual gain from 1926 through 2001.
A closer reading of history books and weekly news magazines like BusinessWeek (founded in 1929) shows investors struggling to cope with cataclysms such as World War II and September 11, mass enthusiasms for radical new technologies like radio and the Internet, and political shocks ranging from trade wars to protest movements. Bear markets follow bull markets, and stocks can languish for lengthy periods of time.
Indeed, an accounting of the market's performance following the end of great bull runs is sobering. It took about two decades for investors to recover their enthusiasm for equities after the peak of 1901. Stocks returned -0.2% from 1901 to 1921, after adjusting for inflation.
ONCE IN A LIFETIME. The Kennedy-Johnson bull market peaked in early 1966, with the Dow Jones industrial average hovering around 1,000. Seventeen years later, the world's most famous market benchmark was still struggling to break 1,000. Taking into account the high inflation of that era, the Dow declined some 60%.
In the last quarter of the 20th century, the stock market transformed a dollar in 1975 into $50 by 2000. The stock market clocked an average annual inflation-adjusted gain of 12% from 1980 to 2001. But once-in-a-lifetime performance ended in 2001. And the aftermath has been painful. "We're not likely to see as good returns as we've seen in the past, because the market has gotten so high," says Robert Shiller, economist at Yale University.
Shiller is a leading academic bear, and the rhythm of spectacular market booms and fearsome busts informs his gloomy prognosis. "For an investment in the overall broad stock market in the U.S. right now, of course, it's very hard to predict. But I think that because it is still priced very high, returns that are close to zero or that are even negative are quite likely over the next 5 or 10 years."
ECONOMIC TIES. O.K., Shiller is a card-carrying pessimist. Other valuation methods suggest prospective returns will come in at a more reasonable rate. The earnings-to-price ratio, or earnings yield, is one method for assessing the market's expectation of long-term stock returns. The real yield on equities in 2001 was between 2% and 3%, depending on whether earnings for members of the Standard & Poor's 500-stock index are adjusted for the business cycle and for accounting problems, says William D. Nordhaus, economist at Yale University and author of the study "The Mildest Recession: Output, Profits, and Stock Prices as the U.S. Emerges from the 2001 Recession" (May, 2002).
Another line of forecasting ties stock returns to the economy's performance. In the long run, stock returns reflect corporate earnings growth, which, in turn, is closely linked to the economy's growth rate.
Economists influenced by Federal Reserve Board Chairman Alan Greenspan assume the U.S. economy can grow at a 3.5% average annual rate without generating inflationary pressures. Add to that the current dividend yield of 1.5%, and a real return of 5% is a sensible probability. The surprise could be on the upside, as companies better exploit the productivity promise of the New Economy's information technologies.
I think a real return between Nordhaus' pessimistic 2% and Bogle's optimistic 9% is still worth pocketing. Equities remain the foundation of any tax-deferred retirement savings portfolio. But we're all going to have to save more and spend less than seemed necessary during the era of double-digit returns in the 1990s. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online