Individual stocks carry a lot of risk - will the company lose its competitive advantage, does it have sustainable cash flow, will it go bankrupt, etc etc. But the stock market as a whole has less risk. That does not mean it is risk free. You overpay for any asset, and you pay for it with low future returns.
In today’s WSJ, Jason Zweig, in his weekly Intelligent Investor column, refers to an article in the J Portfolio Management, authored by the Father of Index Funds, Jack Bogle. To learn more, stay tuned to this thread, as the Outdoors beckon.
Re: The Simple approach to predicting future stock market returns
Per the article, there are three components that contribute to Total Return
1) Dividend yield
2) Earnings Grrowth
3) Expected change in P/E ratio
Mr. Bogle calls the 3rd item a speculative component - we respectfully disagree. (More on that in a subsequent post.
The current S&P500 dividend yield is 2.2%
For expected earnings growth, Mr. Bogle assumes 4.5% (we think this is a reasonable number. Readers can simply google the earnings data over say last 50 years and calculate the rolling annualized 10 yr growth over last 50 years).
Re: The Simple approach to predicting future stock market returns
Depending on which side of the bed you got off of, or who you ask, the P/E value varies - sometimes as wildly as Mrs. Clinton's positions on various issues (ok, not as much).
We recall vaguely that the p/E ratio over the last 20 years has been higher than the norm (over say last 50 years). And the average p to e ratio over the last 20 years is say 19.
Let us assume in 10 years, the p to e drops from 22.5 to 19. If E is the same, that means P drops by 13.5 pct. Using approximation, that is 1.35 pct drop per year over 10 years.
Hence TR = 2.2 + 4.5 - 1.35
=5.35 pct.
Not bad. 5.35 pct annual rate compounded over next 10 years.
Re: The Simple approach to predicting future stock market returns
Drop in p to e from 22.5 to 10 is 12.5. Or 56%.
Average over 10 yrs is 5.6 pct per year.
TR = 6.7-5.6 = 1.1%
So even in the near worst case scenario, one can get an annualized return of 1.1%. This should make the worry wart sleep easy - as long as she don't panic (men don't panic, that's a given).
Re: The Simple approach to predicting future stock market returns
Now let us address the case when the ratio goes to a reasonable 15.5%
Drop of 7/22.5 = 31.5% or 3.15% per year.
TR = 6.7 - 3.15 = 3.55%
That is an annualized return of 3.55 pct.
So the range of returns expected is 1.1 to 6.7% over the next 10 years, with 1.1 pct being close to worst case scenario. (Of course p to e ratios have know to go as low as I think 6). The next post addresses that case.
Re: The Simple approach to predicting future stock market returns
Let us do the analysis for 1 year with P/E at the end of 1 year 10 or 55 pct.
TR 7 - 55 or -48%
If p to e drops to 15.5
TR = 7 - 31 = -24 pct.
So 1 year is too short a time frame. You would not know that with most financial magazines and TV channels asking experts for their 1 year predictions.
This thread is now officially open for discussion.
Re: The Simple approach to predicting future stock market returns
One simple question
Which stocks should I buy?
TLK, this thread was about the S&P 500 Index - which a person can buy through index funds. This exercise allows us to project a range of future returns based on what is know (dividend yield, p to e ratio) and an estimated earnings growth rate (which can be obtained by looking at historical growth rate.) Her 4.5 pct growth is assumed.
One can do a similar analysis for individual stocks to get an initial estimate for future results. But balance sheet becomes very important. Also, goodwill, intangibkes, cash flow (free and operating), pension liabilities, become important. So I would be careful using this simple approach for individual stocks.
Based on valuatuon, big oil stocks were very cheap a week ago. Last week they did jump circa 7 pct.
BP TOT RDS-A COP CVX XOM are some names in big oil.
Caterpillar at 64 was quite cheap. It jumped last week to 69.
I am waiting for a pullback in these shares. If that doesn't happen I won't buy. If it does, will buy little at a time.
Wal mart was also cheap a week ago. Rebounded a bit.
Re: The Simple approach to predicting future stock market returns
Of course the above stocks are a STARTING point. For individual stocks one has to do lot of homework. I would not recommend a stock to buy. I will simply name stocks that I think are potential . opportunities since I think their valuations have come down.
Re: The Simple approach to predicting future stock market returns
What I meant by "I wouod not recommend..." is - lots of folks in the Internet make outlandish statements - stock XYZ will return 100 pct in 2 years etc. I think that is dangerous to the reader.
A person has to look at Balance Sheet Income statement and Cash flow statement.
Re: The Simple approach to predicting future stock market returns
Per the article, there are three components that contribute to Total Return
1) Dividend yield
2) Earnings Grrowth
3) Expected change in P/E ratio
Mr. Bogle calls the 3rd item a speculative component - we respectfully disagree. (More on that in a subsequent post.
As promised, here is why we disagree. Let us assume the long term (last 50 years) average P/E ratio for the S&P500 is 16. (One of the Moderators of this Business forum may volunteer to verify this. Or maybe Mr. Hunt raises his hand - if he is sure, that is.)
The current P /E ratio is 23. Hence it is reasonable to expect reversion to the mean. That Mr. Bogle calls this a speculative component appears to go against the time tested rule that the price you pay matters.