9% Forever?
That's economist Roger Ibbotson's forecast for stock market returns. HE'S BEEN RIGHT--very right--in the past. So how come some people think we shouldn't believe him anymore?

(FORTUNE Magazine) – In May 1974, in the depths of the worst bear market since the 1930s, two young men at a University of Chicago conference made a brash prediction: The Dow Jones industrial average, floundering in the 800s at the time, would hit 9,218 at the end of 1998 and get to 10,000 by November 1999.

You probably have a good idea how things turned out: At the end of 1998, the Dow was at 9,181, just 37 points off the forecast. It hit 10,000 in March 1999, seven months early. Those two young men in Chicago in 1974 had made one of the most spectacular market calls in history.

What became of them after that? One, Rex Sinquefield, went on to found a mutual fund company that now manages more than $80 billion. The other, Roger Ibbotson, kept making market forecasts, forecasts of long-run stock and bond returns that have become deeply woven into the fabric of American life. Simply put, if you believe that stocks are fated to return 10% on average over the long haul, Ibbotson is probably the reason why.

It's hard to overestimate the influence of those numbers. The forecasts and historical return data churned out by Ibbotson Associates transformed the pension fund business in the late 1970s and 1980s, leading managers to make an epic shift out of bonds and into stocks. They formed the inescapable backdrop to the 1990s personal investing boom, as brokers, financial planners, and journalists endlessly repeated the Ibbotson mantra of double-digit stock market returns as far as the eye could see. Lately the Ibbotson forecasts have been finding their way into 401(k)s, as Ibbotson and other firms using similar methods build portfolios for those who opt not to build their own. Ibbotson even sells hundreds of thousands of charts each year showing how stocks build wealth over time--and beat the crap out of bonds.

All this means it's of more than academic interest that an academic debate has been raging for years now over the theories upon which Ibbotson and Sinquefield based their forecast in 1974, and which Ibbotson has followed since. Ibbotson, now 62, has taken some of the criticism to heart, and in the process ratcheted down his long-run forecast for stock returns from more than 10% a year to 9.27%. That alone was something of a shock for many of his clients, Ibbotson says. But a few critics think the real number may turn out to be just 5% or 6%. In that case stocks would barely outperform government bonds--an eventuality that would entirely rearrange the investing world yet again.


The most important thing to understand about the forecast that Roger Ibbotson and Rex Sinquefield churned out in 1974 is that it wasn't an attempt to outsmart or outguess the market as Wall Street seers had traditionally done. Instead, Ibbotson and Sinquefield were simply trying to use the information already embedded in stock prices to, as they put it, "uncover the market's 'consensus' forecast." Their tools were a half-century of historical data and the bold new philosophy of stock market behavior that they had internalized as students at the University of Chicago's Graduate School of Business.

They did it at a time when theories batted about in Chicago classrooms really were changing the world, or were about to. In the early 1970s, Ibbotson says, "everything was going on at the University of Chicago." The professors on his Ph.D. dissertation committee included two future Nobel Prize winners (Merton Miller and Myron Scholes), another who would have won if he hadn't died before the Nobel committee got to him (Fischer Black), yet another whom many colleagues think should win the Nobel (Eugene Fama), and a father of Reagan-era supply-side economics (Arthur Laffer).

Not counting the Black-Scholes options-pricing formula and the Laffer curve, which don't have major roles in this drama, the biggest ideas at the Chicago Business School in the early 1970s were the efficient-market hypothesis and the capital asset pricing model. The gist of the efficient-market idea, as articulated in the 1960s by Eugene Fama, is that today's price is the best possible measure of a stock's value, and that nobody can reliably predict which way prices will be headed tomorrow. The capital asset model says that you nonetheless can predict long-run stock returns because they are a reward for taking risks, and those risks can be measured. While CAPM, as it is known, was devised elsewhere, Chicago's Fischer Black was among its most fervent adherents.

Ibbotson arrived on campus in 1968. He was a kid from the Chicago suburbs who studied math and physics at Purdue and got an MBA at Indiana University. After struggling in the workforce, he went to Chicago to earn a Ph.D. in finance and hit his stride. While still a student, he got a job managing the university's bond portfolio. Meanwhile his friend Sinquefield, a 1972 MBA working at a Chicago bank, was launching one of the first S&P 500 index funds for institutional investors (this when Vanguard was still but a gleam in Jack Bogle's eye). Chicago really was a heady place for young finance geeks in those days.

Ibbotson and Sinquefield both needed up-to-date historical data on security prices for their work, and both knew that the professors who ran the Chicago business school's Center for Research in Security Prices (CRSP) were in no hurry to repeat the epic number-crunching exercise they had undertaken in the early 1960s to build a database of stock prices going back to 1925. So the two men took on the job of updating the CRSP (pronounced "crisp") stock database and assembling a similar price history for bonds and Treasury bills.

They presented their preliminary findings in May 1974 at one of the twice-yearly seminars that CRSP hosted to share the latest academic research with bankers, mutual fund managers, and the like. "Just getting the data was a coup," Ibbotson says. Then there was the forecast, suggested to them by Fischer Black. Black thought of using the data to calculate the additional return that investors had historically received for investing in risky stocks rather than in relatively safe government bonds. According to CAPM theory, this "risk premium" reflects something real and durable about the rewards investors demand for taking the chance of losing money. Real and durable enough, it seemed in 1974, to build a stock market prediction on.

Once Ibbotson and Sinquefield figured out the historical risk premium, all they had to do was add it to the prevailing risk-free interest rate (Treasury bonds or bills, depending on one's planning horizon) to get the "consensus" forecast of market returns. Actually they made it a little more complicated than that: When they finally published their work in 1976, they presented their forecast as the middle point of a wide range of different possible results. The mean forecast for the 25 years through 2000 was for 13% annual stock market returns, with 95% confidence that the return would be between 5.2% and 21.5%. (The actual return was 15%.)

"In some ways it was the first scientific forecast of the market," Ibbotson says proudly. Not everyone saw it that way at the time; some skeptics complained it was just a gussied-up extrapolation of the past into the future. But there turned out to be a ravenous hunger for such data. Both researchers were swamped with requests for more information and advice. For a while Ibbotson, by this time a very junior professor of finance at Chicago, just let the letters pile up unopened in a drawer in his office. In 1977 he decided to make a business out of his research project and started Ibbotson Associates. He also kept teaching at Chicago--until 1984, when his wife, health economist Jody Sindelar, got a job at Yale and he wangled an appointment there as a finance professor. Since then he's left the day-to-day management of the company, still based in Chicago, in the hands of others, while he remains its public face and chief researcher. Sinquefield, meanwhile, launched small-cap index fund manager Dimensional Fund Advisors with another Chicago finance graduate, David Booth, in 1981.


While Ibbotson Associates grew and prospered in the 1980s and 1990s, however, the theories upon which its forecasts are based began to crumble in the face of contradictory evidence. The initial onslaught came from skeptics of the efficient-market hypothesis like Ibbotson's Yale colleague Robert Shiller, who argued that investor mood swings drove stock prices too high or too low for years on end. The experience of the late 1990s confirmed to many that there was something to this. But Ibbotson says he can't base his forecasts on such arguments. "It's not that I believe markets are so efficient," Ibbotson says. "It's just that I don't want to use a mispricing to make predictions." He's trying to divine a middle-of-the-road consensus, not trot out a CNBC-style market call. Fair enough.

A harder-to-dismiss critique came from Mr. Efficient Markets himself, Ibbotson's dissertation advisor Eugene Fama. In a series of papers written with Dartmouth's Kenneth French, Fama has argued that the capital asset pricing model, or at least its 1970s corollary that the risk premium is constant, doesn't match the facts. "My own view is that the risk premium has gone down over time basically because we've convinced people that it's there," Fama says. Ibbotson's stock market forecasting model is thus a victim of its own success.

Ibbotson agrees that Fama has a point, and that he can no longer bank on the historical equity premium to predict future returns. The alternative he has come up with is an estimate based on fundamentals. He takes the 10.31% annual return on stocks from 1925 through the present and strips out the tripling of the market's price/earnings ratio that's occurred since then. "We think of that as a windfall that you shouldn't get again," he says. The drivers of stock returns that remain are dividends, earnings growth, and inflation. Make a forecast of future inflation using current bond yields, assume that dividend and earnings growth history will repeat themselves, and you get a long-run equity-return forecast of 9.27%. When Ibbotson and his company's director of research, Peng Chen, first ran the numbers in 2001, the gap between the new forecast and the one using the equity premium method was more than a percentage point. Because P/Es have dropped since then, the gap has shrunk. But Ibbotson's revised forecasting method doesn't insulate him from criticism any more than the old way. In fact, it invites new criticism.

The most persistent challenger has been Rob Arnott, a Pasadena money manager and editor of the Financial Analysts Journal, who thinks future equity returns could be below 6%. (See "Dueling Market Forecasts" chart.) The big difference between his forecast and Ibbotson's is that Arnott uses the current dividend yield (1.76%) as a starting point, while Ibbotson goes with the much higher long-term average yield (4.23%). Ibbotson believes the historical number provides a better picture of what investors think is ahead. He still relies on the assumption that markets are efficient, so current dividend yields must be low for a reason--his guess is that investors are expecting big growth in earnings (and dividends) in the future. Arnott, whose research has shown that low yields in the past were followed by slow earnings growth, thinks that's balderdash. "One of my biggest beefs with the academic community is the notion that theory is fact," he complains. "When they find evidence that contradicts the theory, instead of saying, 'Wonderful, let's improve the theory,' they throw it out because it conflicts with theory."

But the theoretical assumption that the market knows best is central to Ibbotson's whole forecasting endeavor, something even Arnott acknowledges. "In a sense Ibbotson is trying to infer what the consensus view is," Arnott says. "I'm trying to profit from that consensus." What Ibbotson is telling us is that the market still believes stocks will handily outperform bonds over the long haul. And if the market turns out to be wrong about that, it won't just be Roger Ibbotson who feels the pain.

FEEDBACK jfox@fortunemail.com