Domestic Equity

In contrast to bonds, the payments you expect to receive when you purchase a share of stock are much less certain. In essence, a share of common stock is claim on what is left of a company’s cash flows after everyone else who is owed money has been paid (e.g., suppliers, workers, taxes, bondholders, etc.). For example, while you know the current dividend paid on each share of stock when you buy it, there is no that this dividend will remain the same in the future. Depending on the company’s business success, the cash available to pay it may increase or decrease. And the company may choose to do something with it other than paying dividends. Alternatively, it could use it to buy back some of its shares (which in some countries is more tax efficient than paying dividends), or it could invest the cash to expand its business.

In addition, the price of the share itself will fluctuate in the future. Broadly speaking, five factors combine to determine the future price of a share you buy today. First, there is the current dividend paid, which is the cash flow you expect to receive in the short term as a result of owning the share. Second, there is the rate at which these dividends are expected to increase in the future. The next two factors determine the rate at which these future cash flows are discounted back to their present value today. The third valuation factor is the current rate of interest on government bonds (also known as the "risk free" rate), and the fourth is the extra amount of return investors require to induce them to invest in risky equities instead of risk free government bonds. This extra amount is known as the "equity risk premium". Taken together, these first four factors are often said to determine the "fundamental" or "rational" value of a share of equity.

However, as anyone who experienced the 1990s is well-aware, rational factors aren’t the end of the story when it comes to determining equity prices. Hence our fifth factor: investor emotions. There are times when equity prices, either of a single share or of a market as a whole, rise to levels that are difficult (to put it mildly) to justify based on reasonable estimates of our first four factors. These are the times when momentum tends to be the key factor determining current share prices – in other words, people’s belief that share prices will increase in the future simply because they have done so in the past, without any reference to the changes in the fundamental factors that would justify (or undermine…) those beliefs. Of course, such attempts are sometimes made – who during the tech boom didn’t read an article claiming that future growth rates would be incredible, or that the equity premium was now close to zero? With respect to domestic equities as an asset class, the key point to make is that while these statements may occasionally be true for individual shares (e.g., Microsoft in 1985), they are hardly ever true for an equity market as a whole, and virtually never true at the same time. For example, while rapid real growth in dividends might be expected for an economy emerging for a war, equities would probably still be quite risky under these circumstances. Alternatively, if I knew a big increase in inflation was coming, and could only invest in equities or fixed rate bonds, the real equity risk premium might decline (based on the assumption that equities would do better than bonds under these circumstances). However, there would be no reason to expect the growth of dividend payments to also rapidly increase (as real economic growth tends to fall during periods of high inflation).

The bottom line is this: domestic equities are relatively riskier than many other asset classes, and as such should generally produce higher returns in normal times, and lower returns in difficult times. And, as the following table shows, that is pretty much what has happened since 1971.

Real Domestic Equity Returns Under Different Conditions
Geometric Annual Returns for Decades, Quarterly Returns for Quarters

It is equally informative to look at the distribution of real returns on different domestic equity indexes over the entire 1971 to 2002 period. The following table shows arithmetic average annual returns, standard deviations, skewness and kurtosis for these indexes.

Real Domestic Equity Returns 1971 to 2002

This table makes a number of interesting points. First, as was the case with domestic bonds, developed country capital markets seem to have been reasonably efficient over the past thirty years, with average annual real returns on equity in a fairly narrow range across our six currency regions. The same is true for their volatility (standard deviations), which, apart from commodities, are relatively higher than those for the other asset classes we have so far discussed. It is also the case that across our six regions, real domestic equity returns tend to be moderately correlated with those on domestic bonds, and have low correlations with real returns on commodities. Looking at the last two columns, one can see further evidence that domestic equities are a risky asset class on which one should expect to receive commensurately high returns in normal periods. Skewness is negative(returns below the average are more likely than returns above it), and kurtosis is higher (and relatively extreme returns more frequent) than would be the case in a normal distribution.

Thus far, our comments about domestic equities are relatively uncontroversial, and in line with those by other commentators. The real challenge today, for us and for every other financial writer, is developing a reasonable estimate of the returns domestic equities may provide in the future. Let’s take a look at the issues at the heart of the argument.

As we described above, to induce them to hold equities instead of government bonds, rational investors require an additional return premium. One way to summarize this relationship is to say that an investor's required return on equities (in real terms) equals the current real return on government bonds, plus the current real equity risk premium. Think of this as the demand side of the equity market valuation equation.

The other side of the question (call it the supply side) is the level of returns equities as asset class will produce in the future. Fundamentally, these returns are a function of two factors: the current dividend yield on equities (i.e., annual dividend/current price) plus the real rate at which dividends are expected to grow in the future. We should note at this point that there is a question as to whether or not share repurchases should be added to dividends (which, in effect, would raise the dividend yield). Technically, the answer is yes, but practically it seems to be no. Share repurchases are, like dividends, a means of returning cash to stockholders. Practically, however, they are undertaken only episodically, and occur much less frequently than dividends are paid. Moreover, studies which have included them have reached conclusions that are very similar to those that have used dividends alone. So we have elected to just use dividends in our analysis. There is also a question as to whether or not we should take changes in the market price/earnings ratio into account when estimating the future supply of equity market returns. We have chosen not to do so because P/E changes are driven by psychological factors which are extremely difficult to predict.

By taking both demand and supply side factors into account, you can develop an estimate of whether or not a market is currently overvalued. For example, if the average return the equity market is expected to supply is greater than the return a rational investor should demand, then the market could be said to be undervalued. On the other hand, if the rate of return the market is expected to supply is less than the rate of return a rational investor would demand, then the market is probably overvalued..

When it comes to putting this approach into practice, the good news is that two of the variables in this model can be obtained relatively easily: the current yield on real return government bonds, and the current dividend yield on the equity market as a whole. The bad news is that the correct values for the other two variables -- the equity market risk premium (ERP) and future rate of dividend growth -- are two of the most contentious issues in finance.

Let's look at these issues in more detail.

Until recently, the most common approach used to estimate the equity risk premium was to look at historical rates of return on equity and government bonds, and use the average difference between them as the equity risk premium. The following table contains historical estimates of equity risk premia. The first set is the difference between the rate of return on the Morgan Stanley Capital International Equity Index for the country or region in question and the rate of return on government bonds with maturities of five years or more, between 1985 and 2000. The second set is from the book Triumph of the Optimists (by Elroy Dimson, et al), and is based on the period between 1900 and 2000.

Third, using the overall growth rate for economic output as the growth rate for dividends implies that corporate earnings remain a constant share of GDP, and than dividend payout rates (dividends/earnings) also remain the same over time. However, both of these have been fairly volatile over time. Between 1960 and 2002, corporate earnings averaged 10.7% of GDP in the United States, but with a standard deviation of 1.7%. In recent years they were as high as 12.5% in 1997, and as low as 9.0% in 2001. Over the same period, dividends averaged about 53% of after-tax corporate profits, but with a standard deviation of about 15%.

A look at different real growth rates over time provides a different perspective on the issue. Between 1960 and 2002, real economic growth in the United States arithmetically averaged 3.34% per year. During this same period, annual labor productivity growth averaged 2.24%, implying annual labor force growth of 1.10% per year. At the same time, real after tax corporate earnings in the United States grew by only 2.89% per year on average. Why did real after tax corporate profits grow more slowly than real GDP? Taxes aren’t the answer, as real corporate pre-tax profits grew by only 2.23% per year on average (in other words, corporate tax cuts helped boost profit growth over this period). And don’t blame labor – real employee compensation grew by only 3.05% per year. The true culprit was interest payments, which rose by 6.37% per year on average over the 1962 – 2002 period, reflecting both greater use of debt and high real interest rates during some of these years (when the real rate of interest is greater than the real rate of GDP growth, the share of GDP going to interest payments will increase).

On the other hand, real dividend payments grew by 4.38% per year on average over the 1960 – 2002 period. However, dividends can’t forever outgrow the after-tax earnings from which they are paid. At the extreme, while an economy might be able to raise its dividend payout ratio above 100% of after-tax earnings for a few years through some combination of increased borrowing and asset sales, this can only continue for a very short time. Over the long term, growth in after-tax corporate earnings is what counts when it comes to generating real dividend increases.

So where does all this data leave us? All in all, this data leads us to conclude that, despite the uncertainties involved, expected GDP growth derived from assumptions about future labor force and productivity growth isn’t a bad starting point for estimating the rate at which after-tax corporate earnings will grow in the future. However historical data suggests GDP growth on its own historically has been biased on the high side as an estimator of future earnings growth. Should we adjust it downward in the future? If you assume that the scope for adding additional amounts of leverage to a nation’s balance sheet is limited (as it probably is in most major markets today), this question boils down to whether or not you believe that in the future real interest rates will be greater or lesser than the real rate of GDP growth. If you believe they will be greater, then interest payments will absorb an even greater share of future GDP, and corporate earnings growth will (with no change in the share going to labor) be less than GDP growth. On the other hand, if you believe future real interest rates will be less than future GDP growth, then there is no reason (absent any change in labor’s share) to adjust GDP growth downward to estimate future corporate earnings growth. So which is it?

As of mid-2003, the yields on real return bonds range from a high of 2.92% in Canada to a low of 1.70% in the Eurozone, and even less in Japan (based on subtracting the forecast change in prices from current nominal bond yields). The following table shows these real bond yields, along with forecast economic growth based on two different productivity assumptions: the recent historical average, and an optimistic case of one percent over the historical average.

Future Rates of Return on Domestic Equities: The Growth Factor

From this analysis, it looks like we should downwardly adjust GDP growth to project future corporate earnings growth in Canada, and the less optimistic cases for the Eurozone and UK. The size of this adjustment will be .5% (one half of one percent).

The following table therefore derives our estimates for future returns on the domestic equity asset class in each region by combining the current dividend yield with our low and high estimates for future growth in after-tax corporate earnings. When we use these estimated future returns to develop new model portfolios, we will use the high estimate for future equity returns, and the historical standard deviation over the 1971-2002 period.

Future Estimated Real Annual Rates of Return on Domestic Equities: Summary

We can already hear you saying: Wait a minute! These estimates seem low compared to what we’ve gotten used to. What’s going on? In a nutshell, we began the last big bull market with dividend yields much higher than they are today – 5.4% in 1981 in the U.S., or, more recently, 6.6% in Australia in 1990. These yields fell to their current levels as equity market valuations (prices) were driven upward by the powerful combination of falling interest rates and, undoubtedly, a decrease in the equity risk premium people required, and/or an increase in their perception (however inaccurate) of the rate at which earnings would grow in the future.

The essence of the issue is that when dividend yields fall so much it is basically impossible to make up the difference through faster future earnings growth. Mathematically, future returns must be lower. Moreover, if at the same time real bond yields and/or investors’ required equity risk premium is moving higher, a situation could easily be created in which the real return on domestic equity that investors demand is higher (perhaps significantly so), than the real rate of return on equities the economy seems likely to supply. This is the set of conditions that could precipitate a sharp decline in equity prices (but which would also increase the dividend yield, and in so doing set the stage for higher future real returns on equity). In sum, the situation is both dynamic and uncertain, which is why we track equity market valuation conditions each month in The Retired Investor.

So, to sum up the arguments in favor and against investing in the domestic equity asset class: