What's Weighing On The Market?
By Justin Fox

(FORTUNE Magazine) – This year's stock market probably has you flummoxed. It's down! It's up! It's down again! The daily headlines offer plenty of explanations for the bad days--profit warnings, slow job growth, uncertainty about the presidential race, and worries about oil, Iraq, and terrorism. But they miss a bigger truth: The market is struggling because we are living in a time of inevitably lower stock returns. Get used to it.

The case for why stocks won't deliver the big gains that they did over the previous two decades has been made in these pages before, but it's worth going over. Stock prices are driven by two things: earnings per share and how much people are willing to pay for those earnings (a.k.a. the price/earnings ratio). There is no conceivable way that earnings alone can get us anywhere near the double-digit returns of the 1980s and 1990s, or even the 7% real (after inflation) return that--according to the Wharton School's Jeremy Siegel--stocks delivered over the past two centuries. Where can earnings get us? Probably to an annual return of, at best, 3% or 4%. That leaves P/Es. Forecasting them is something of a fool's errand, but there are many reasons to think that they're too high right now rather than too low.

Put earnings and P/Es together, and you get a market that should sputter for years to come. Sure, there will be occasional comebacks, as in 2003. But with long-run returns in the low to middle single digits, big run-ups will inevitably be followed by years like this one. Or worse.

This is not a forecast of gloom and doom: The U.S. economy may do just fine over the coming decades. Much of its growth will come from exciting new companies selling exciting new nano-things or bio-things or low-carbo-things or whatever. This is the glory of capitalism. But because most of those businesses either don't exist yet or don't have shares you can buy on an exchange, today's stock investors won't get to profit from all of the economy's growth. "Your share of the economy will be diluted," says Robert Arnott, a Pasadena money manager and editor of the Financial Analysts Journal. "It's a simple fact."

This might seem a petty concern after a 12-month period in which the S&P 500's earnings per share rose 27%. But that kind of growth won't last. For one thing, there is a limit to how big a share of the economy workers and the government are willing to cede to corporations (see chart below). With after-tax corporate profits' share of GDP hitting 7.9% in the first quarter, matching a record set in 1965, that limit would seem to have been reached. Corporate profits simply cannot sustain a growth rate faster than that of GDP.

And that's corporate profits, a measure tabulated by the Commerce Department that encompasses all corporations, public and private. The earnings per share of existing publicly traded corporations will, because of the dilution outlined above, grow more slowly than that. How much slower? Arnott, who has done a lot of research on this subject, says that if GDP growth continues at its 20th-century average of 2.7% a year, the earnings per share of existing publicly traded companies will rise 1.1% annually.

To get what economists call the internal rate of return of stocks, you add that growth rate to the dividend yield, which has lately been fluctuating between 1.6% and 1.7%. So what Arnott is forecasting is about a 2.75% annual real return on stocks, assuming that P/Es remain unchanged. Tweak the assumptions in an optimistic direction, putting economic growth at 3.5% and reducing Arnott's dilution haircut a tad, and it's possible to get returns of just over 4%. But there's also the risk that the economy will grow more slowly than in the past, and once you start cutting the GDP forecast much below 2.7%, you come to a world in which stock returns trail the 2.5% yield you can currently get from inflation-protected government bonds called TIPs--an effectively risk-free investment.

Which brings us back to those P/Es. The only way stocks can beat TIPs by a substantial margin (that is, a margin anything like the 3.5% premium stocks have historically enjoyed over bonds) is for P/Es to rise. Right now the market's P/E is about 25 (measured using the past ten years' reported earnings, adjusted for inflation). That's well below the 45 it hit during the 1999--2000 bubble but well above the long-run average of 15. "Do P/Es have to come down?" asks Cliff Asness, a University of Chicago finance Ph.D. who now runs AQR Capital, a hedge fund in Greenwich, Conn. "No. There's nothing magical about historical averages."

Asness cannot, though, see how P/Es could go much higher, because that would reduce stocks' premium over risk-free bonds even further. A more likely scenario is that as it becomes clear to investors that EPS growth really does lag economic growth, more and more of them will bail out of the stock market, eventually driving P/Es so low that stocks are an indisputable bargain. This entails a substantial fall in stock prices, but at least it means future investors will again be able to make the big gains that the stock market has traditionally delivered. The greatest enabler of the great bull market of the 1980s and 1990s was, after all, the bear market of the 1970s.

It's possible, though, that investors have decided that stocks aren't as risky as they once thought, and are satisfied with only a tiny premium over bond yields. If that's the case, the market could putter along at a 2% to 4% inflation-adjusted pace for decades. Stock prices would have finally reached the "permanently high plateau" that economist Irving Fisher infamously spoke of in 1929. The only problem is that you'd be hard-pressed to find a plateau on a stock chart. Ups and downs, with a lot more down years than we've become accustomed to, seem more plausible.

What is an investor to do in such a situation? First, if you have good reason to think that you know how to pick the next hot stock or the next hot money manager, by all means do it. The academic hypothesis that no one can consistently beat the market no longer has many adherents. But there's no denying that the average investor cannot beat the market average--and most of us are probably best off assuming that we are in fact average when it comes to investing. We have jobs, we have lives, we have magazines to read. We can't really expect to trounce the market in the spare time that remains. That is why the study of the market's long-term potential return is such important business. In a world where even most mutual fund managers deliver below-average performance, it's crucial to have some sense of what that average will be.

The first step in learning to deal with this lower-return world is to ratchet down your expectations. You can still double your money at 3% a year. It will just take 23 years.

If you're picking someone to manage your money, the best predictor of future performance is cost. Vanguard founder John Bogle has shown in several studies that the mutual funds that charge the lowest fees generate the best long-run returns. That doesn't mean you have to buy a Vanguard index fund, just that on balance you're better off picking a fund that doesn't gouge you.

Another obvious strategy for a low-return world is to diversify into investments other than stocks. The question is, what? Real estate certainly doesn't look like a bargain (see cover story). And while commodities and emerging-markets debt have been spectacular performers over the past couple of years, they seem to be fully priced now too. "Lately we have moved to a broader diversification than ever before," says Arnott, who decides the asset mix for the Pimco All-Asset fund. "That simply reflects that there are no low-hanging fruit."

At current prices, that means even a low-return stock market will outshine most other asset classes--although it's still worth diversifying to temper the market's ups and downs. Within the stock market, the most obvious strategy for beating the averages is to concentrate on the oft-neglected half of the return equation: the dividend yield. Buy a stock with a dividend yield of 5%, and you're already ahead of the overall market as far as potential return. That will, of course, do you no good if the company paying the dividend is on the road to ruin. But solid, slow-growth stocks paying out 4% or 5% a year--a category that includes giants like Altria (MO, $49), Bank of America (BAC, $44), BellSouth (BLS, $27), and Southern Co. (SO, $30)--are potentially a very good deal these days.

Merrill Lynch strategist Rich Bernstein even predicts that stocks that pay big dividends will see their P/Es rise in years to come because retiring baby-boomers will be more interested in getting income from their stocks than capital gains. Such are the strange side-effects of life in a low-return world.

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