Forget promises of 10%

Experts advise investors to lower expectations on stock returns

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Listen to a stockbroker or financial planner hawk his services and you will almost certainly hear words to this effect: You can expect the stock market to return an average of 10 percent a year over the long term.

That statistic is trotted out with such certitude that most investors accept it as financial gospel. But can investors who start buying stocks today expect that kind of return over the next 10, 20 and 30 years?

"From 2005, guess the length of time that is needed to assure the long-term average," said Ed Easterling, president of Crestmont Research, a Dallas investment research firm. "The answer: Probably never."

Easterling is not alone in his effort to lower investor expectations. An increasing number of financial experts and academics believe market returns over the next few decades won't match those of previous decades.

A more realistic return - or, as Easterling puts it, a return that a rational investor can expect - is 6 percent to 7 percent. The respected Leuthold Group, a Minneapolis research firm, also estimates long-term market returns in that range.

"It's unreasonable for investors to expect double-digit returns," said Eric Bjorgen, senior research analyst at Leuthold. "Too many investors tether their expectations to what happened in the last 20 years, but that's not likely to happen again in our lifetime."

A look at stock market history will show why. The average compounded annual return of the Standard & Poor's 500 index from 1926 to 2004 is 10.4 percent, according to Ibbotson Associates Inc., a Chicago research company. Many people assume the same returns over the next few decades and project from that how much they will accumulate for their retirement.

They are betting that another market bubble will push stock valuations to the limit, as happened in the late 1990s, Bjorgen said.

"That period was a statistical outlier, an aberration, that comes around maybe every 75 years," he said. "Rational people shouldn't base their financial expectations on the madness of crowds."

Three components contribute to total stock market returns: earnings, dividends and the change in stock valuations.

Historically, corporate earnings have grown 6.1 percent annually, and that figure includes an inflation rate of 3 percent.

Many investors have the skewed notion that the double-digit earnings growth in recent quarters is the norm. It's not.

As with stock market returns, the long-term future of earnings growth is likely to be below average.

"We got record earnings growth beginning in 2002 after one of the biggest bubble collapses in history in 2000," said James Stack, editor of InvesTech Research and a market historian. "Just wait until the next recession when earnings growth turns negative again, and people will understand that earnings don't always grow 15 to 20 percent."

Even to get to 6 percent, a healthy dose of inflation is needed. And that's anything but certain, because the Federal Reserve has become increasingly adept at controlling inflation.

Easterling predicts a low inflationary environment that would reduce the earnings contribution to long-term stock returns by 1 percentage point. That would make the average annual market return from 10.4 percent to 9.4 percent.

Dividends, the second component of stock market returns, have accounted for a sizable portion of returns over the years. The average dividend yield of the S&P 500 since 1926 is 4.5 percent, according to Ibbotson.

(Dividend yield is the annual cash dividend that companies pay their shareholders divided by the stock price. A company that has a stock price of $10 a share and pays a dividend of 45 cents a share has a dividend yield of 4.5 percent.)

Investors shouldn't count on a 4.5 percent dividend yield in the future, though, because stock prices are much higher now relative to earnings than they were in the past. To better understand this, consider the company above with the $10 stock price and 45-cent dividend.

If the stock price climbed to $20 a share, the company would still be paying the 45-cent dividend, but the yield would drop to 2.3 percent because the stock price is higher.

The stock market today is more expensive than it was 79 years ago. This is determined by looking at the market's price-to-earnings (P/E) ratio. The P/E ratio is a company's share price divided by its earnings per share.

A company with a $20 stock price and earnings of $2 a share has a P/E of 10.

In 1926, the price-to-earnings ratio of the S&P 500 was 10. Today it is 19, nearly double. In other words, today you pay about twice as much for every dollar of earnings.

"That explains why dividend yields today are about half of what they were 79 years ago," Easterling said. "So the market's return from dividend yields will be about half of the historical average as long as valuations stay at this level."

That takes the average annual market return from 9.4 percent to 7.2 percent.

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