What Long-Term Return Should We Expect On large-capitalization Stock Market Indexes?

Source: http://www.investorsfriend.com/return_versus_gdp.htm

The answer is, in the long-term Stocks will return a percentage that is roughly equal to (actually slightly lower than) the Rate of Nominal GDP Growth Plus the average Dividend Yield. This is demonstrated below with logic and graphs of the historic data.

Investors putting their money into stocks need to understand what long-term average return they can reasonably expect.

This article shows that a reasonable estimate for the average long-term compounded stock market returns on the overall market index is roughly in the range of 7%. And that is before deducting trading and investment management costs. This is based on U.S. data, but would also apply very similarly to Canada.

Many analysts forecast the long-term average return based strictly on historic returns. For example, the Dow Jones Industrial Average Total Return (including reinvested dividends), has returned, as of the end of, 2012, a yearly average of about 11.0% per year since 1930. On a compounded basis this is equivalent to a steady return of 9.1% per year compounded. (Compounded average returns are lower than average returns due to the impact of volatility). So, some investors might predict a future 9% long term average return. Other investors observe that stock indexes have made meager returns of less than 3% per year for the S&P 500 from 2000 through 2012 since the year 2000 and might therefore predict something like 3% going forward.

A 9% per year as a compounded long-term average is a return level that most investors would be happy to achieve in 2013 and as along-term future return. And the highly volatile and low average 3% total return from the S&P 500 realized from 2000 through 2012 would not entice most people to invest. But what return should we expect from stocks going forward?

Some analysts (most notably Warren Buffett in Fortune Magazine November 22, 19991) argue that future long-term stock market returns can be estimated based on GDP growth and the dividend yield.

The math is simple, according to Warren Buffett1 and others, we can roughly forecast the long-term expected return from major large-capitalization stock market indexes as:

Expected real GDP Growth + Expected Inflation + Expected Dividend Yield

The advantage of this simple method is that long-term forecasts of the three variables are available.

Today, a reasonable estimate of long-term expected large-capitalization stock market returns according to this formula might be:

3% for real GDP growth + 2.0% for inflation + 2.0% for dividend yield = 7.0% long-term total return on stocks.

Equivalently; 5.0% for nominal GDP growth + 2.0% for dividend yield = 7.0% long-term total return on stocks.

Many of us might describe a 7.0% long-term average compounded stock market return as being somewhat disappointing. And it is particularly disappointing when we consider that we need to deduct trading and management fees of about 1% to 2%,and we also need to deduct something for income taxes.

You can argue about the numbers to assume in the above formula. This is especially so today when GDP growth has been low and where some fear deflation and others fear hyper-inflation. But most long-term forecasts for these variables would total something close to our 7.0% figure. However, you can plug your own estimates into the simple formula if desired.

But are long-term stock market returns really related to GDP, inflation and the dividend yield in this way? Certainly, short-term stock market bear little relationship to this formula. But what about the long-term? What does history tell us?

The graph below provides the answer based on data for the Dow Jones Industrial Average, which is a large-capitalization stock index. The graph is based on rolling 30 year holding periods to simulate actual investor experience over different time periods. Each point on the graph below is the compounded average percentage gain in the Nominal GDP or the compounded average total return on the Dow Jones Industrial Average over the past 30 years.

In fact, history tells us that over most historical 30-year periods long-term stock market returns on the DOW Jones Industrial Average (the red line) were actually usually lower than the growth in GDP plus inflation plus the dividend yield. The notable exceptions are the 30 year rolling periods ending in 1999 through 2012, the DOW total return, at over 12% (the red line here), exceeded the growth in GDP plus the compounded average dividend yield (the blue line). In 1999 and 2000, the fact that the DOW returns over the previous 30 years exceeded GDP + inflation + dividend yield was due to the very high stock market valuation. In more recent years the out-performance was more likely due to a very low starting point for the DOW in the 70's and early 80's.