Why You Should Stop Worrying and Embrace the Bear Market
August was a rough month for the stock market. So rough, in fact, that what started off as a promising year for stock investors now looks decidedly less so, with the total stock market now off more than six percent year-to-date.
Further reinforcing the dour mood is the "lost decade" we've just endured. While my colleague Allan Roth and others have pointed out that the past ten years were far from "lost" for investors who bought and held a prudently diversified portfolio of stocks and bonds, the fact of the matter is that domestic stocks have an outsized influence on the mood of investors. When they're going up, we feel a bit wealthier; when they're falling, we feel a bit poorer.
But while that response might make sense as you examine your current portfolio, the fact of the matter is that it makes little sense for the millions of investors who are in the accumulation phase, making regular weekly or monthly contributions to their 401(k)s, IRAs, and other long-term savings accounts. Because the fact of the matter is that every point lost in the stock market today increases the expected long-term return on their stock portfolio. And -- assuming those contributions are faithfully made through thick and thin -- those future returns will have a far greater impact on their wealth than just about anything the market can do this year.
Over the years I've seen few analysts improve upon John Bogle's methodology for estimating future stock market returns, so let's use his lens to take a look at the market today.
Let's start with the dividend yield, which rises as markets fall. This is a core component of the market's long-term return, and today it stands at 2.2 percent -- not nearly as high as it's long-term average of some 4.5 percent, but a far cry from the 1 percent dividend yield of the late-1990s.
To this we add the market's expected earnings growth over the coming decade, which historically has averaged about six percent on a nominal basis. Combining that figure with the current dividend yield gets us to an expected return of 8.2 percent for the next ten years.
To that we must add -- or subtract -- the annualized change in the market's price-earnings ratio over the coming decade. There's no good way of estimating what investors will be willing to pay for $1 of corporate earnings ten years from now, but it's fairly safe to expect that the future P/E ratio will be roughly what it's averaged over the long term -- or approximately 16 times earnings.
The market's current P/E ratio is 14. If it climbs to 16 over the next decade, that will add about 1.3 percent to the market's annual return. When we combine the 8.2 percent return with a 1.3 percent boost from an increase in the market's P/E ratio, we get an expected ten-year nominal return of 9.5 percent.
It could of course be higher or lower. If P/Es fall to ten over the decade, that will slice more than three percent from the market's return; if they rise to 20, the boost will be 3.3 percent. But again, in establishing expected long-term returns, it's safest to expect a return to long-term averages.
But it's important to consider this expected return on stocks in relationship to returns provided their primary alternative, bonds. Today, a diversified portfolio of Treasury and high-grade corporate bonds is yielding approximately 2.5 percent, which means that the expected ten-year return is somewhere between two and three percent annually -- paltry by just about anyone's standards.
So does that mean you should abandon your bond funds and load up on stocks? Good heavens, no. It simply means that at current valuations the stock market is priced to provide you with a rough premium of six to seven percent per year relative to bonds -- a nice compensation, on other words, for having endured the volatility that it's been dishing out recently.
As Warren Buffett put it many years ago, the stock market is the only marketplace in the world in which shoppers rush in to buy when prices rise and race for the exits when everything goes on sale. So if you're still in the accumulation phase of your investment lifetime, stop worrying and embrace the bear, for today's decline simply increases the long-term value proposition that stocks offer.
Most Popular This Week: