Reading the Future?

An equation may reveal your stocks' five-year return

In planning for the financial future, one key question is how much you can expect to earn on your investments. For stocks, the default answer has been 10.7% a year. That's the long-term average for large-cap stocks over the past 75 years, as reported by Ibbotson Associates.

The problem with that answer: It's an average over decades that tells you nothing about what might happen in the next 5 or 10 years--the time frame you might really care about. Two Seattle University finance professors have come out with what might be a better way to make that critical estimate. The equation involved is so simple even your sixth-grader could use it.

Professors Ruben Trevino and Fiona Robertson studied price-earnings ratios for the Standard & Poor's 500-stock index and its subsequent returns from 1949 to 2000. They found that high p-e's meant lower returns over the next five to 10 years. Also, you can estimate the five-year average annual stock return simply by multiplying the current p-e by 0.57, then subtracting the result from 20.67.

How does that work given today's market? Start with the p-e. The trailing p-e (the current price divided by the past 12 months' earnings) for the S&P 500 now stands at 46, more than three times its historic level, as calculated by Standard & Poor's. (You can get this information at www.spglobal.com/earnings.html.) Right now, that number is high because the past 12 months have been miserable for corporate earnings. Using the professors' equation, five-year annual returns would average a negative 5.6%.

But trailing p-e's always look high, especially when an economy is coming out of a recession. Suppose you substitute a p-e based on the next 12 months' earnings estimate. The "forward" p-e is 26, says S&P. That makes stocks look better, with an average annual return of 5.9%. But this is still far below long-term average returns.

Some big firms are telling investors to temper their expectations. A recent report from Merrill Lynch's quantitative strategy group says a 5% to 6% range is more reasonable than the 10% to 12% historic norm. T. Rowe Price Group predicts the high single digits, perhaps 7% to 9%, in the next 5 to 10 years, says spokesman Steve Norwitz.

Whichever projection you accept, it may mean working longer or saving more for retirement. Given returns of 7%, a $100,000 investment would grow to only $196,715 in 10 years, vs. $276,361 at 10.7%.

The professors caution that their findings are only "suggestive." They add there's no way to know how an equation based on history will apply when starting with today's unheard-of p-e levels. But Trevino thinks investors will get more accurate prognostications using his formula than by plugging in the historic average. Yale University economist Robert Shiller, author of the best-selling Irrational Exuberance, agrees--to a point. "Let's not think of it as God's revealed truth," he says of an equation designed to predict the future.

Even noted market bull Jeremy Siegel says the next 5 to 10 years will likely bring lower market returns. He predicts the S&P will yield 7.5% to 10% (or 5% to 7% after inflation). But for Siegel, a finance professor at the University of Pennsylvania's Wharton School, the problem is not so much an outsized p-e. Instead, he argues, stocks had been undervalued, so investors shouldn't expect as great a premium for holding them now.

For investors, that may be just another way of saying the same thing as the Seattle profs: Forget those plump double-digit returns in the coming decade.

By Carol Marie Cropper

Before it's here, it's on the Bloomberg Terminal.
LEARN MORE