Disturbing Numbers Follow On

I have continued looking at the data.

The Total Return = the Investment Return + the Speculative Return.

The Investment Return = the initial dividend yield + the annualized growth rate of dividends (i.e., dividend amounts).

The Speculative Return = the effect of changing multiplies (e.g., P/E10).

Now to look at some more numbers. All values are adjusted for inflation.

Using Averages

1881-2004 Averages
P/E10 = 16.10.
Annualized 10-Year Growth in Dividend Amount D: 1.15% per year.
Speculative Return: 0.72% per year.

1901-2000 Averages
P/E10 = 15.40.
Annualized 10-Year Growth in Dividend Amount D: 1.18% per year.
Speculative Return: 0.77% per year.

1921-1980 Averages
P/E10 = 14.55.
Annualized 10-Year Growth in Dividend Amount D: 0.92% per year.
Speculative Return: 0.12% per year.

1921-1950 Averages
P/E10 = 12.97.
Annualized 10-Year Growth in Dividend Amount D: (0.30)% per year.
Speculative Return: 0.98% per year.

1951-1980 Averages
P/E10 = 16.12.
Annualized 10-Year Growth in Dividend Amount D: 2.14% per year.
Speculative Return: (0.75)% per year.

1981-2004 Averages
P/E10 = 20.98.
Annualized 10-Year Growth in Dividend Amount D: 1.02% per year.
Speculative Return: 6.89% per year.

Using Medians

1881-2004 Medians
P/E10 = 15.61.
Annualized 10-Year Growth in Dividend Amount D: 1.06% per year.
Speculative Return: 1.11% per year.

1901-2000 Medians
P/E10 = 13.98.
Annualized 10-Year Growth in Dividend Amount D: 1.38% per year.
Speculative Return: 1.15% per year.

1921-1980 Medians
P/E10 = 13.52.
Annualized 10-Year Growth in Dividend Amount D: 0.88% per year.
Speculative Return: 0.82% per year.

1921-1950 Medians
P/E10 = 11.48.
Annualized 10-Year Growth in Dividend Amount D: 1.54% per year.
Speculative Return: 1.17% per year.

1951-1980 Medians
P/E10 = 16.90.
Annualized 10-Year Growth in Dividend Amount D: 2.72% per year.
Speculative Return: 0.09% per year.

1981-2004 Medians
P/E10 = 20.00.
Annualized 10-Year Growth in Dividend Amount D: 0.93% per year.
Speculative Return: 7.77% per year.

Analysis

These numbers show the Speculative Return directly. Comparing medians and averages, most of the time the speculative return has been positive. It has been of the order of 1%. It averages about 0.5% less as the result of occasional sharp declines.

P/E10 rose from 13 to 16 on average (and from 11.5 to 17 using medians) from the 30 years leading to 1950 to the 30 years that followed.

This reconciles the use of P/E10 in the Stock-Return Predictor. The calculated long-term return is 6.5% to 6.8% when P/E10=13.7. If we enter 14.55, which is the 1921-1980 average, we get a predicted Year 10 return of 5.89%, a predicted Year 20 return of 5.98% and a predicted Year 30 return of 6.61%.

All of this is consistent with my earlier observation: the Investment Return calculated with the Gordon Model is close to 5.9% these days, where Gordon Model estimates are most accurate between Years 5 and 15.

We might consider an upward adjustment to P/E10=16 as being the modern norm. If so, the calculated long-term returns are 4.98% at Year 10, 5.33% at Year 20 and 6.36% at Year 30.

The 1981-2004 data are way out of line with everything else. There really was a bubble. It added a Speculative Return of 7% to 8% per year.

Conclusions

We should increase our choice of a “typical” level of P/E10 to 16 to represent the post 1950 market. I selected this value from the 1951-1980 data, which is pre-bubble.

I did not choose later returns. They differ markedly from historical norms. They were distorted by bubble psychology. They averaged P/E10 levels above 20, which is not enough to support a long-term return above 5%. Yet, they produced Speculative Returns in excess of 7%.

Real dividend growth has averaged 1% per year overall and 2% per year during the 1951-1980 period.

These are the changes for planning purposes:

1) The “typical” P/E10 level has increased to a new, permanently higher plateau of 16 (but not anywhere close to 20 and above).

2) The Year 10 real, annualized, total return under “typical” conditions is 5% per year.

3) For dividend growth calculations, we should set the market (S&P500) standard at a real return of 5% per year (8% nominal).

Have fun.

John Walter Russell
January 23, 2007