2. For all Panelists: Is a 7% Stock Forecast Prudent?

["Steven H. Johnson" <info@sscommonsense.org>]

Again, this question is asked in the quality circle spirit of 
everyone working together to find a truly robust solution.  

C.  Is it prudent to forecast seven percent real returns for 
stock investors in the future?

It has been said that an S&P 500 index fund investor would have 
earned average real returns of 7% on the stock market, adjusted 
for inflation, over the past seven decades.  This is roughly 
right.

It has also been said that 7% returns are as likely in the next 
seven decades as they were in the last.  Indeed, the Archer-Shaw
proposal is premised on this assumption.  Yet this assertion 
seems highly questionable.

Seven percent returns consist of two ingredients:  Price 
appreciation, and Reinvested dividends.  Of the two, dividends
have played a much more important role in the total return
equation than has price appreciation.

Price appreciation averaged 2.3% a year, for the S&P 500 index, 
once inflation is taken out.  
It lagged 3.3% real GDP growth by a full percentage point.  
If the growth rate of the workforce slows from 1.4% a year to 
0.4%, as predicted, then we're likely to see the GDP growth rate 
slow as well.  
And, it would seem, we're also likely to see the long-run 
S&P 500 price appreciation rate slow correspondingly.

The dividend yield, for S&P 500 companies, averaged 4.6%.
For the stock market as a whole, the aggregate dividend yield 
was a little lower - perhaps 3.6%, or 3.8%.

The only way for the dividend yield in the future to be the same 
is for the conditions that we had in the past to repeat themselves, 
wouldn't you agree?
Aggregate dividend payouts have to be roughly the same, relative 
to GPD.
And the aggregate market capitalization of the entire stock market, 
relative to GDP, would also have to be roughly the same.

It's not unlikely that aggregate dividend payouts will be roughly 
the same.  They seem to run a steady two-and-a-quarter to two-and-
a-half percent of GDP, no matter what else is happening in the 
economy.

But doesn't it seem unlikely that the aggregate market 
capitalization will average 65% of GDP over the next seven 
decades, as it did over the last seven?  With the Market 
Capitalization-to-GDP Ratio is somewhere up around 170% or 180% 
now.  Even if it drifts down from that level, in the years to 
come, as it surely will, it's unlikely to be nearly as low in 
the future as it was in the past.

Low Market Capitalization-to-GDP Ratios are associated with high 
inflation rates, high interest rates, high discount rates, and 
low P/E multiples, are they not?  And high Market Capitalization-
to-GDP Ratios are associated with low inflation rates, low 
interest rates, low discount rates, and high P/E multiples, 
right?

So, if we assume low inflation, low interest rates, and low 
discount rates, we can also assume higher P/E multiples and 
higher Market Capitalization-to-GDP Ratios in the future.

Which means that we have to assume lower aggregate dividend yields, 
does it not?  The higher the price of the stock on which a 
dividend is earned, the lower the yield rate.  The higher the 
aggregate value of the total stock market on which total 
corporate dividends are paid, the lower the aggregate yield 
rate for the market as a whole.

That's the argument from logic.  It merely underlines the question:
Is it prudent to forecast 7 percent returns?  

Now, if you like, read on.
The same argument on stock returns can be made from a different 
set of empirical data.

If you look at the Market Capitalization-to-GDP Ratio over time 
(too bad this forum doesn't support charts as part of our 
submissions - it's quite a fascinating chart), you can see four 
distinct phases in stock market capitalization.

1.  There's a Trough-to-Trough Phase.  Market Cap-to-GDP Ratios 
are low throughout.

2.  There's a Trough-to-Peak Ramp-Up phase.  Market Cap-to-GDP 
Ratios start out low, but a growing economy and rising P/E 
multiples carry the market to a substantially higher price level.

3.  There's the Peak-to-Peak Plateau Phase.  Market Cap-to-GDP 
Ratios remain high throughout.

4.  Finally, there's a Peak-to-Trough Crash.  P/E ratios tank, 
and Market Cap-to-GDP Ratios go into a precipitous slide.

Let's look at the returns that would be earned by an S&P 500 
investor in each of these phases.
We'll assume that our hypothetical investor has real wage gains 
of one or two percent a year, and that he, or she, puts aside an 
equal percentage of payroll each year into an S&P 500-based 
index fund, with all dividends reinvested, and no management fees 
or taxes assessed.

Our hypothetical investor does do one thing that's a little 
unusual, though.
She starts investing at the beginning of a phase, and then cashes
 out at the end.
She does this, obviously, to accommodate our desire to learn more
about the relative returns to an investor, as a function of the 
phase in which they're investing.
Note the returns she earns, phase by phase:

1936 - 1942.  Peak to Trough Downturn. Real returns of - 4.7%.  Ouch!
1942 - 1953.  Trough-to-Trough Phase.  Real returns of  +7.5%
1953 - 1961.  Trough-to-Peak Ramp-Up.  Real returns of  +11.6% 
1961 - 1972.  Peak-to-Peak Plateau.  Real returns of  +5.5%.
1972 - 1974.  Peak-to-Trough Crash.  Real returns of  -26.3%.  An even bigger OUCH!
1974 - 1984.  Trough-to-Trough Phase.  Real returns of  +8.0%
1984 - present.  Trough-to-Peak Ramp-up.  Real returns of  +15% or better.

Here are the associated figures for Market Capitalization-to-GDP Ratios:

1936 - 1942:  Market Cap-to-GDP Ratio falls from about 100% to about 35%
1942 - 1953:  The ratio fluctuates between 35% and 50%
1953 - 1961:  It rises from about 40% to about 90%
1961 - 1972:  It fluctuates between 80% and 105%
1972 - 1974:  It collapses from about 95% to about 41%
1974 - 1984:  It fluctuates between 40% and 55%
1984 - present:  Market Cap-to-GDP Ratio rises from about 43% to about 175%

The trend patterns yield several insights.

Obviously, the market's a harsh place to be during a Peak-to-
Trough Crash.
The 1936-1942 downturn wasn't pleasant, with low negative returns.
And the 1972-1974 downturn was horrific, with steep negative returns.

And the stock market's quite wonderful during a Trough-to-Peak ramp-up.  
Returns in the 1953 - 1961 ramp-up were quite nice, and returns 
in the 1984-Present ramp-up have been even nicer.

But - here's the interesting question.
Are returns better during a Trough-to-Trough phase, when stock 
prices are low, and dividend yields high?
Or better during a Peak-to-Peak phase, when stock prices are 
higher, and dividend yields lower?

Think about it.

In turns out that an S&P 500 investor actually does quite a bit 
during a Trough-to-Trough period. 
The 1942-53 Trough-to-Trough period produced real returns of 7.5%.
The 1974-84 Trough-to-Trough period produced real returns of 8.0%.  
By contrast, the 1961-72 Peak-to-Peak phase produced real 
returns of only 5.5%. 

Why?  Lower stock prices, during a Trough, mean higher dividend 
yields.  And higher rates of return.

What does this say about future rates of return?  
Considering the market phases that await us next, after the 
current Trough-to-Peak phase ends.
And considering the likelihood that future market phases
will take place at somewhat higher capitalization levels than past 
market phases.

To repeat the question to the panelists:
I'd be most interested in your thoughts on the advisability of 
forecasting real returns of seven percent as part of any Social 
Security reform package.

-Steve Johnson

PS.  My graph on the Market Capitalization-to-GDP Ratio can be 
found at http://www.sscommonsense.org/page04.html