Ten years ago Vanguard founder John C. Bogle addressed a group of financial journalists. He explained, with elegant simplicity, why he didn't think the nineties would be a replay of the eighties. He was wrong then, but his idea is more important today.

He said the return on common stocks has three sources--- dividends, earnings growth, and changes in how much an investor will pay for a dollar of earnings. Earnings growth and dividends, he added, usually run around 10 percent.

So higher (or lower) equity returns were usually the result of changes in price-to-earnings multiples.

Stock returns in the eighties had been about 17 percent annually, largely because investors were willing to pay more for a dollar of earnings. Indeed, price-to-earnings ratios had doubled over the decade.

Mr. Bogle then laid out three scenarios for stock returns in the nineties:
  • The status quo, with no P/E change, provided an annual return of 11 percent;
  • His worst case assumed poor earnings growth and shrinking p/e multiples, providing a return of only 5 percent;
  • His best case assumed good earnings growth and a modest increase in P/E multiple, producing a return of 15 percent--- a near replay of the nineties.
As it turned out, the nineties were a replay of the eighties.

As it turned out, the nineties were a replay of the eighties.

Stocks again provided very high returns. P/E ratios rose for another decade. Even now, P/E ratios for large capitalization stocks stand at near record levels.

Which brings us back to expectations.

What if the future is more like the distant past? What if our destiny is to watch stock valuations return to average levels over the next 10 or 20 years?

If that happens the return on common stocks over the next ten years will range from a high of 8.2 percent to a low of 1.2 percent. Stretch the change in P/E over two decades--- so it duplicates the rise from 1982 to 2001--- and the return will be about 5 percent. However you slice it, we may be looking at 10 to 20 years of lower than normal returns. (The figures are shown in the table below.)
Estimating Future Stock Returns
Source of Return Stable Decade Back to Average Decade
Dividend Yield 1.2% 1.2%
Earnings Growth 7.0 7.0
Change in P/E ratio 0.0 -7.0
Total 8.2 1.2
Notes: Yield is current S&P 500 rate; Earnings growth long-term average is 7 percent; Change in P/E assumes no change or back to long-term average.
Impossible, you say?

Sorry. Such results are not only possible but part of post war history. Starting in 1960, according to Ibbotson Associates data, every 10-year period for the next 14 years had a return under 9 percent. If you had started investing in any year from 1960 through 1973, your return over the following 10 years would have been under 9 percent. The best of those 10-year periods was 1971-1980, with 8.44 percent. The worst was 1965-1974, with 1.24 percent.


It's also possible to have returns below 9 percent for as long as 20 years. The twelve 20-year periods beginning in 1955 had returns ranging from a high of 8.66 percent (1966-1985) to a low of 6.53 percent (1959-1978).

What does it mean, if we must change from Great Expectations to Expecting Less? Here's a list of ten shifts:
  • Bonds are more competitive with stocks. We should own more. (There are signs this is occurring.)
  • Relatively new obligations such as Treasury iBonds and TIPS (Treasury Inflation Protected Securities) are likely to be very competitive with stocks.
  • Stocks with dividends that grow should get more of our attention.
  • Paying off debt will be very competitive with investing in stocks.
  • Retirement plans need to increase savings or defer retirement, or both, to compensate for lower investment returns.
  • Low investment management expenses will be even more important than now.
  • Maximizing the use of tax deferred or no-tax plans (IRA, SEP, 401k, 403b, and Roth IRA) will be even more important.
  • Income-consuming toys like boats, RVs, and exotic cars accumulated over,the last 20 years are likely to be in flux. The high-maintenance toys are likely to become bargains.
  • Sources of imputed (non-cash) income such as mortgage-free second homes and condos will look like better investments.
  • Solutions for Social Security will shift from privatization to extending the retirement age as the perceived benefits of privatization decline.
To read the 1991 column explaining John Bogle's method.