What drives stock market returns
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What drives stock market returns

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  • My name is Patrick Collins and I am a principal and wealth manager at Greenspring Wealth Management. With all of the turmoil the equity markets have seen over the past three years, we thought it would be a good idea to get back to basics and look at the drivers of stock market returns. Forecasting future returns requires advisors and investors to understand these metrics and how to evaluate them. This short presentation is meant to give you an understanding of what drives stock market returns, where are we now and what are some probable return scenarios in the future.
  • Please take a moment to read these important disclosures.
  • Most people believe that growth in our ecomony’s GDP (gross domestic product) is the main driver of stock market returns. This slide shows that economic output (which tends to drive corporate profits, employment and government spending, to a degree) has very little correlation to the returns in the stock market.This is a key point to understand since many people will make their investment decisions based on factors like whether the economy is performing well, the latest jobs report, or earnings releases from corporations. This slide shows that these factors have very little impact on returns. A good example would be the last decade in our economy. Our nation’s GDP averaged over 4% growth per year while our stock market lost value. In fact over the past 110 years , GDP actually has grown faster in bear markets than bull markets. All of these statistics just go to show that using economic growth as a reason to buy or sell stocks is a losing proposition.So what are the factors that influence stock market returns?
  • Dividend yields, earnings and the Price to Earnings ratio determine stock returns. There is a fairly simple formula that can be used to calculate returns, the only problem is that we don’t know the inputs in advance. The earnings of the stock market (or for an individual stock for that matter) times the price to earnings ratio which is basically what the general market is willing to pay for those earnings plus dividends received will give you the stock market’s return. Therefore, we thought it would be useful to understand these three factors and use history as a context when trying to forecast the future.
  • Dividend yields have been fairly steady (when compared to the other two factors) over the past 140 years. The dividend yield is simply the dividends received divided by the price, in this case of the S&P 500. As you can see the dividend yield of the S&P 500 has been trending down except for a few spikes for the past 90 years. Instead of paying out cash to shareholders, corporations have elected to use it to invest in productive assets. The current dividend yield of the S&P 500 is approximately 2 percent which means that if the market’s price does not appreciate for the next 10 years, as long as dividends remain stable, investors will receive approximately 2 percent per year in returns. It is interesting to note that in this low interest rate environment the dividend yield is not much less than investing in many bonds which have no growth potential.
  • The next two slides have to do with the second factor in the equation: aggregate earnings of the companies in the S&P 500. As you will see, earnings have grown exponentially over the past 130 years and there is no reason to believe that this trend will end over the next 130 years. This chart shows that growth is the normal state of the economy and periods of stagnation are more the exception than the norm. Earnings are the second part of the equation and are key to stock market returns. The more a stock earns, theoretically the more it will be worth. While this is not always the case, it is one part of a three part equation.
  • While over the long-term earnings tend to grow, during shorter time periods, earnings can be volatile. This chart shows rolling 10 year earnings growth rates of the S&P 500 companies. You will see that over 10 year periods earnings growth have ranged from over 170% to negative 25%. The average 10 year earnings growth is approximately 55%. We use normalized earnings which is an average of the S&P 500s earnings over the past 10 years. That average is approximately $49 per share today. Interestingly, the actual earnings today stands around $75 per share. The normalized or average earnings number is much less since it is averaging earnings from the last 10 years which saw two recessions. Therefore, we believe moving forward, it is reasonable to expect normalized earnings growth to come in well over it’s long term average of 55%.
  • The third part of the equation, P/E ratio, is the hardest to forecast and most influential component of stock market returns. The Price to earnings ratio is simply what the market is willing to pay for a stream of earnings. There are a multitude of factors that influence this ratio like investor sentiment, interest rates, and future economic prospects. We used an example earlier showing that during the past decade there was negative growth in the stock market but positive GDP growth in the United States. This chart shows you why the stock market had negative returns in the face of a growing economy. In 2000 the P/E ratio was at an all time high with investors willing to pay nearly 45 times a company’s earnings to purchase that company’s stock. While the economy (and in most cases the earnings of those stocks grew) the price investors were willing to pay for those earnings shrunk dramatically causing market returns to turn negative over the past decade. The average P/E ratio over the past 130 years has been 16, while we are currently at 19, just slightly above the average. It is impossible to know where the P/E ratio will be in 10 years, but it is comforting to know that the value of our stock market is well within a normal band and should not be a major contributor to either negative or positive returns in future years, barring an extreme shift in valuation like in 2000 or the early 1980s.
  • Now that we have reviewed the three factors that drive market returns, we thought it would be useful to go through an exercise to forecast future market returns. Again, reviewing the formula, we’ll need to calculate where earnings will be in 10 years, what the market will be willing to pay for those earnings (PE ratios) and the dividends received. As you will see below we have provided some ranges for both earnings and the PE ratio to see how those assumptions will translate into market returns.It is important to note, that these assumptions and results are not guarantees of future performance and returns could be outside our ranges if our assumptions are wrong. Earnings growth assumptions are listed and are elevated from average growth levels for many of the reasons we mentioned earlier. Also, the PE ratio listed are a wide range of potential outcomes. Let’s take a look at the results
  • The matrix lists the 10 year average annual return of the market using several different scenarios. If you throw out the two extreme scenarios you find that market returns range between 0.2 and 9.2%. Because dividend yields are historically low and we are starting from a slightly overvalued market (compared to the long-term average) we think it is reasonable to expect stock market returns to fall short of their long-term average over the next 10 years.This has implications for investors, pension funds and endowments who should most likely think about these findings when developing their expected returns. At Greenspring we have ratcheted down our expected returns from equities when developing our financial projections for clients in light of these findings.We hope you enjoyed the seminar. Feel free to contact us at www.greenspringwealth.com if you have any questions.

What drives stock market returns What drives stock market returns Presentation Transcript

  • Presenter
    J. Patrick Collins Jr., CFP®, EA
    Wealth Manager & Principal
    What Drives Stock Market Returns?
  • Disclosures
    Please remember that different types of investments involve varying degrees of risk, and that past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any investment strategy, including the investments or investment strategies recommended by Greenspring Wealth Management, Inc. in the presentation will be profitable or will correspond to any index or past performance. A copy of our current written disclosure statement discussing our advisory services and fees continues to remain available for your review upon request.
    Please note that investments in this presentation may not be suitable for all investors and this presentation should not be a substitute for personalized advice from Greenspring Wealth Management, Inc or from a professional advisor of your choosing.
    The comments in this presentation are current as of September 2010 and my not be reflective of the current strategy or recommendations of Greenspring Wealth Management. The Investment Committee may modify its recommendations at any time based on current information or developments.
    Please remember to contact Greenspring Wealth Management, Inc. if there are any changes in your financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add to, or modify any reasonable restrictions to our investment management services.
  • It’s Not The Economy
    Average Annual Change (Compounded)
    By Decades
    Source: Crestmont Research
    Source: Crestmont Research 2010
  • Three Factors
    Dividend Yield
    Earnings
    Price to Earnings Ratio
  • Dividend Yield
    Source: Robert Shiller, Irrational Exhuberance
  • Earnings
    Data Source: Robert Shiller, Irrational Exuberance
    Source: Robert Shiller, Irrational Exhuberance
  • Earnings Growth Rates
    10 Year Normalized Earnings Growth per Share of S&P 500
    1891-2010
    Data Source: Robert Shiller, Irrational Exuberance
    Source: Robert Shiller, Irrational Exhuberance
  • Price-to-Earnings Ratio
    Normalized Price-to-Earnings Ratio of S&P 500
    1881-2010
    Data Source: Robert Shiller, Irrational Exuberance
    Source: Robert Shiller, Irrational Exhuberance
  • Forecasting Returns
    FORMULA
    Earnings X P/E Ratio + Dividends
    CURRENT STATISTICS & ASSUMPTIONS
    Current S&P 500 Value: 1,140
    Current Dividend Yield of S&P 500: 2%
    10 Year Earnings Growth (from current normalized value of $49 per share):
    Low: 70%
    Mid: 95%
    High: 125%
    P/E Ratio:
    Low: 10
    Mid: 16
    High: 24
    Source: Robert Shiller, Irrational Exhuberance
  • Forecasting Returns
    10 Year Average Returns Matrix of S&P 500
    This chart is for illustration purposes only and is not a guarantee of future results.
    Source: Robert Shiller, Irrational Exhuberance