Ten years ago, the S&P 500 yielded about 1.4 percent. The price-to-earnings ratio was close to 28 times. Earnings over the decades have grown about 6 percent per year. To calculate the expected return 10 years ago, we would take the dividend (1.4 percent) plus the earnings growth (6 percent) plus the change in valuations. Given that stocks historically sell at 18 times earnings on average, a change in valuations from 28x to 18x implied an expected loss over the decade of 36 percent in valuation, or about 3.6 percent loss per year. In total, a reasonable expected return would have been about 3.8 percent per year (1.4 percent yield + 6 percent earnings growth – 3.6 percent valuation change). Since the decade ended with valuations at only 12x earnings, investors didn’t even make the low expected 3.8 percent return. Rather, they lost about 1 percent per year.
What about the decade ahead? The dividend yield is currently 3.3 percent. Let’s assume the same historical 6 percent earnings growth. With the price-to-earnings at 12x, the market is selling below normal valuations – a 33 percent discount. Using the same process, the decade beginning 2009 should provide reasonably good returns of roughly 14.3 percent per year (3.3 percent yield + 6 percent earnings growth +5 percent in valuation change).
Does 14.3 percent annualized return sound okay with everyone?