Jeremy Siegel, Ph.D. The Future for Investors

Although the Standard & Poor’s 500 Index is still just below its all time high reached in March 2000, many high-profile market analysts, including Jeremy Grantham of GMO and Cliff Asness from AQR Capital, are pessimistic. They claim that profits are at a cyclical peak and that a low dividend yield will generate poor future returns for stocks.

Yet I believe the opposite is true and think that the current valuation of the stock market is very favorable for investors. Before explaining why, let me respond to these bears.

The Bear Case

It’s true that last year the level of after-tax corporate profits relative to gross domestic product (GDP) reached 11.4%, slightly exceeding the previous highs set in 1929 and the late 1940s.

One reason is that an ever-increasing share of the profits of U.S.-based firms is being earned in faster-growing overseas economies. As a result, it shouldn’t be surprising to see the ratio of U.S. corporate profits to U.S. GDP rise.

But more importantly, corporate profits are only one form of the return to capital. Of nearly equal dollar value is what is called “proprietors’ income,” which is the return to private and partnership capital.

The share of proprietors’ income has been trending downward over most of the last fifty years as more capital migrates into corporate entities. This transformation has particularly been strong in the financial sector, where many commercial banks, brokerage houses, investment banks, and government sponsored enterprises such as Fannie Mae and Freddie Mac have become public corporations. Once this shift is taken into account, the total profits to corporate and non-corporate capital, now at 20% of GDP, is only slightly above its post World War II average and is not at all at record levels.

Another bear claim is that the long-term real earnings growth rate of 2% is insufficient to generate good returns at current 2% dividend yields. But 2% real earnings growth is no longer relevant to today’s market. Earnings per share have been growing more rapidly not just because of the cyclical expansion but also because of the low dividend payout ratio. This has allowed firms to buyback record number of shares, thereby boosting per share earnings growth. In essence, firms are trading dividend yield for capital gains, a trade motivated by the tax advantages of capital gains and the proliferation of management options.

Earnings Growth

Future returns are linked to current valuations. One the most widely used measures of stock market value is the price-earnings (P-E) ratio, the price that investors are willing to pay for a dollar’s worth of earnings. But the reciprocal of the price earnings ratio -- the earnings yield -- is the key to projecting real stock returns.

The earnings yield for stocks is analogous to the “coupon yield” of the bond, which is the ratio of the coupon to the market price and measures the “current yield.” But there’s a big difference between the earnings yield and the coupon yield. The coupon yield is a yield insofar as the bond’s coupon is fixed in money terms. But the earnings of a firm is based on real assets whose value will, over time, increase with the rate of inflation. Therefore the earnings yield is a real yield.

The historical data confirm this contention. In the United States, data of corporate profits go back to 1870 and the average P-E ratio during that period has been 14.4, leading to an average earnings yield of 6.9%. This is one-tenth percentage point above the average real return on equities, which is 6.8% over the period.

What then are the current prospects for earnings growth? Estimates for 2007 earnings on the S&P 500 Index range from $89 for the very conservative “core earnings” developed by Standard and Poor’s to a more optimistic $94 per share for operating earnings. With the index at roughly 1490, this leads to a current P-E ratio of between 15.8 and 16.7 and a bit lower if we extend the next twelve months through the first quarter of 2008.

This P-E ratio corresponds to an earnings yield of between 6% to 6.5% on S&P 500 stocks and an identical estimate of real return. This real return can be broken into a real per share earnings growth of 4% to 4.5% per year plus a 2% dividend yield.

Valuations Could Go Higher

Even though current returns on stocks look good, I believe that stock returns may even be higher. Two characteristics in today’s financial markets argue for higher long-term P-E ratios: the steep drop in transactions costs, which permits low cost global diversification, and the reduction in economic volatility, which lowers the equity risk premium.

Two factors have led to the reduction in transactions costs: the sharp drop in brokerage fees, starting 30 years ago with the deregulation of commissions and the collapse of bid-ask spreads that has accompanied the increase in global liquidity. These factors have enabled investors to acquire and maintain a fully diversified portfolio at a small fraction of one percent per year, far less than the one to two percentage points that existed when brokerage costs and bid-asked spreads were much higher. And low-cost diversification has now extended to global indexes.

The second factor arguing for higher stocks prices is the decline in the variability of real economic variables. Economists call the reduced volatility of the economy “The Great Moderation” and have attributed it to better central bank policy, more precise inventory controls, and a growing service sector, which is inherently more stable than manufacturing. A reduction in economic variability reduces the risk premium that investors demand on stocks above the return on safe assets.

These factors could boost the average future P-E ratio for equities to 20, with a resulting earnings yield of 5%. Once these higher price levels are reached, stocks will not likely offer the 6 ½ % to 7% real returns that have marked their historical average. But a 5% real return on stocks still yields a 3% premium over inflation-indexed bonds, a margin that many money managers consider very reasonable.

If these new higher valuations come to pass, then stocks will on average be priced about 25% above their current levels. Even if stocks do not reach this higher valuation, equities at today’s valuation are priced to yield a real return of 6% to 6.5%. This return is much higher than bonds and I would argue considerably higher than available on real estate at today’s high prices.

No one can predict stock market returns from year to year. But longer run returns must be based on current valuations and the case for equities is very persuasive at today’s prices.