The Capital Wire: THE FUTURE RETURN ON EQUITIES DEBATE

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As an extension to the debate over Social Security privatization, the debate over future equity returns is heating up here and here. It is framed around the 6.5% average annual rate of return that equities have yielded over the past 100 years and whether this same yield is attainable for the next 75 years. Proponents of privatization proclaim that nothing has changed to expect anything less than the historical average, while opponents cite such things as current rich valuations as a hindrance to such expectations. This 6.5% assumption over the next 75 years is the soul of the privatization proposal, as anything much less than that number compromises the proposal’s merit.

I’ll leave it to the pundits to slug it out over the specifics of future dividend yield/growth, GDP growth, P/E multiples and whatever else is baked into the prices of equities. But here are some qualitative points to keep in mind:

- Those that assume that the 6.5% return of yesterday signals a 6.5% return for tomorrow ultimately fail to appreciate the common disclaimer that past performance does not ensure future results. Just ask any ex-trader who’s been bludgeoned by the market for carrying such a nonsensical mindset.

- Stocks have historically been a superior investment relative to other classes such as bonds, but only when priced right in the beginning. It could be that valuations were cheap in 1900 whereas today they are expensive (21x peak earnings), or that dividends were high relative to today’s low yields. A starting dividend yield of 4.2% goes a long way toward explaining the 6.5% total equity return. Today, dividend yields are nowhere near 4.2%.

- Higher prices paid today generally leads to lower expected returns tomorrow. Because valuations are historically high, expected future returns on stocks are lower than they have been in the past. Meaning that by buying stocks today, the margin that stocks yield over bonds would be much slimmer than what has historically been the case. Now the question becomes how much slimmer, and is the added yield (equity risk premium) enough to compensate investors for added risk – after all stocks are inherently riskier than bonds as they are upon liquidation a subordinated claim on assets.

I’m of course leaving out much more, but it’s a start. For those that need a refresher on this subject, refer to the heavyweights: work by Rob Arnott and Peter Bernstein (monographs available here), Dimson, Marsh, & Staunton, and Ibbotson Associates (all predict lower future equity returns) – and as a counterweight, Jeremy Siegel and Glassman/Hassett, who hold more optimistic views.