Where Do Market Returns Come From???
This is kind of simplistic, but a good primer on what drives stock market returns.
Equity markets occasionally react to what is going on today. But in general, equity markets are forward looking. In other words, how does what happens today translate into the future? If the markets feel that because of, or despite of, what happens today that the future is getting better, then the markets will improve, they will go up. Or vice versa. That does not mean that the markets will go up 10, 20 percent every year.
Components of Expected Equity Returns: Asset Inflation, Dividends, Earnings Growth, PE Expansion/Contraction
Remember, these are what the market expects from forward looking numbers, not the current numbers. But we can play using the current numbers.
= Asset Inflation: CPI 1.7% (current)
+ Dividends: S&P 500 1.96% (current)
+ Earnings Growth Rate: S&P 500 3.0% (current)
+/- PE Expansion/Contraction: ???
1.7% + 1.96% + 3.0% = 6.66%
The S&P 500 PE Ratio on 10/3/11 was 11.8. The low in the last five years was 10.4 on 3/9/09. The S&P 500 PE Ratio on 11/5/13 was 16.7. That’s 44% in 2 years, or about 20% per year. 6.66% + 20% = 26.66%. The 1 year return on the S&P 500 as of 11/5/13 was 23.42%. So, we’re in the ball park (it’s economics, accuracy is NOT expected). Let’s say the PE ratio expands 1 point in the next year, from 16.7 to 17.7, that’s a 6% expansion
6.66% + 6% = 12.66% Expected Market Return for the next year, IF inflation, dividends and earnings increase at the current rate AND PE Ratios expand 6%.
The one thing I can tell you is that inflation, dividends, earnings, and PE expansion ARE NOT going to stay the same. One, two, three or all of them are going to change.
Assistant State Treasurer
Chief Investment Officer
State of Louisiana
Department of the Treasury