Tuesday, October 19, 2010

The Make-Up of 10 Year Stock Market Returns

Analysis of the contribution of dividends, earnings growth and valuation to past returns raises some red flags regarding the next 10 years. Near-all-time-low dividends are providing less protection than dividends have historically provided for investors. In addition, after two decades of steadily increasing p/e ratios, the chances of valuation making a negative contribution to returns appear to be increasing.

Components of 10-Year Stock Market Returns

Earnings, dividends & price/earnings (p/e) contribution to rolling 10-year stock market (Dow) returns
Contribution to 10-Year Stock Market Returns

Above is a graph of 10-year returns of the
DJIA (Dow Jones Industrial Average) from 1920 through 1994. (Click on image to expand.) This is really just a more detailed version of the rolling 10-year returns graph from an earlier post. For each year, I show the annualized returns earned by an investor who bought the Dow Index at the end of that year and held for the next 10 years, reinvesting all dividends during the interim. As usual, I'm ignoring the impact of commissions, taxes, etc.

The 10-year returns for each year are represented by a stacked bar consisting of three segments:
  • The white segment shows the contribution that dividends made to total return for the 10-year period.
  • The blue segment shows the contribution made by growth in normalized earnings -- average earnings including the five prior and five subsequent years. (I describe my normalization methodology in more detail in this post.)
  • The red segment represents the impact of changes in valuation -- in this case, increases or decreases in the normalized price/earnings (p/e) ratio; this is also known as earnings multiple expansion and contraction.

Understanding the Graph: Examples

When all three segments of the yearly bar are positive, the chart is easy to read. For example, we see that in the 10 years beginning (end of year) 1950, the three segments total about 15%. This is the same as the performance shown in the rolling 10-year return graph. The three "legs of the stool" were almost equally responsible for the performance: earnings growth contributed 4.5% per year, dividends 5.0%, and the increase in p/e ratio from 9.9 to 16.6 added another 5.6% per year to returns.

When a year has both positive components and negative components, they must be netted against each other. For example, for the 10 year period labeled "1964," valuation detracted 9.6% per year. That's because between year-end 1964 and year-end 1974 the normalized p/e ratio plummeted from 19.1 at the height of the 60's euphoria to 7.4 at the depths of a brutal bear market. The 9.6%/year loss almost completely offset 6.2% per year in earnings growth and 3.7% in dividends. Add the three together and the net is 0.3% -- the same near-zero 10-year performance we see on the rolling 10-year graph.

The Contribution of Dividends to 10-Year Returns: The White Segments

As you can see, historically, dividends have been the most consistent contributor to stock market performance. For many years, dividends contributed 4-5% per year -- or even more; partially as a result, 10-year total returns have almost never been negative.

The Contribution of Earnings Growth to 10-Year Returns: The Blue Segments

Unlike dividends, the contribution from earnings growth can be negative -- but it very rarely is. Earnings growth is, however, cyclical -- reflecting, among other things, the waxing and waning of the business cycle.  Here we see growth cycling mainly in the 3 - 10% range; in the long-term, it has averaged a bit less than 6% (see this post).

The Contribution of Changes in Valuation (P/E Ratio) to 10-Year Returns: The Red Segments

The wildcard in this equation is clearly valuation. It is the only factor of the three that is negative as often as it is positive. If the normalized price/earnings (p/e) ratio is higher at the end of a 10 year span than at the beginning, then the change in valuation will make a positive contribution to total return for that period; it will increase the investor's total return. If the normalized p/e is lower at the end of the 10 years than at the beginning, then the change will make a negative contribution.

The impact of valuation changes cannot stay positive forever since this would mean ever increasing, and ultimately infinite, p/e ratios. The impact cannot stay negative forever since that would mean ever decreasing p/e ratios; however, p/e ratios cannot go below zero.

Red Flags Based Upon Stock Market History

There are two obvious causes for concern here. First, since around 1980 dividend yields have been in decline. As a result, dividends currently provide less of a cushion than they have historically provided against potential downturns. (See Dow Dividend Yield History)

Secondly, in the past, valuation has alternately contributed to returns for an extended period of time, and then detracted from returns for a similar period. This is the alternation of excitement and disinterest I first alluded to in 100 Years of Stock Market History. Valuation has been contributing to, "spicing up," investor returns for the last two decades. If history repeats itself, we would seem to be due for a period where valuation detracts from returns.

Note: The above chart is based on DJIA (Dow Jones Industrial Average) data from my Stock Market Analysis Model. Results would be comparable if we used S&P 500 data. Dow earnings and dividends prior to 1929 have been estimated based upon another stock market index.

Related Posts
Other Posts in this Composition of Returns Series
The Extraordinary Impact of P/E Ratios: Same as this graph, but for 1-year periods.
Earnings & Dividends Determine Long-Term Returns: Same as this graph, but for 50-year periods.
Analyzing & Understanding Stock Market History: Introduces the Stock Market Analysis Model I use to decompose returns.

Additional posts showing the relationship between valuation and future returns:
Dow P/E Impact on Future Returns historical dollar impact of investing at high P/E vs low P/E ratios.
Starting P/E Ratio vs 10-Year Stock Market Returns: a scatter diagram showing the impact of the initial P/E ratio.
Borrowing Returns from the Future: additional analysis of the scatter diagram, focusing on the exceptional readings.
Rolling Returns vs. Initial P/E Ratios: similar to above 2, but a time series graph.
For lists of other popular posts and an index of stock market posts, by subject area, see the sidebar to the left.

Copyright © 2010           Last modified: 9/1/2013

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