Seeing the future

• Investors should look ahead for various possible scenarios and be prepared for different outcomes.
• There are three components that account for 100% of equity returns. An in-depth understanding of such three components provides a solid understanding of what the future may have in store for us, and how we can develop reasonable or likely expectations of future equity returns.

When he was asked about the secret for his success, Wayne Gretzky replied:"I skate where the puck is going, not where it has been". In the world of investing, no metaphore can be closer to the truth. Not that the past does not matter. It does. But if you get fixated on the back mirror, accidents can happen. It pays to look ahead for possible scenarios and be prepared for various possible outcomes. In this update, we offer a simple framework for determining possible market outcomes, what is the likelihood of each and how you can plan your financial life accordingly.

Last week marked the passing of the legendary John Bogle. In his book entitled "Common Sense on Mutual Funds", John Bogle explained in a very simple, yet very elegant way, how equity returns are determined, and what are the three components that account for such returns. The title of the corresponding Chapter was "Occam's Razor", in reference to William of Occam's principle, which essentially states that simpler solutions are more likely to be correct than complicated ones. In honour of John Bogles's memory, and because we believe in keeping things simple, we will use the same framwork to outline possible future outcomes of equity markets, 10 years from now.

The three major components of equity returns are dividends, earnings growth and variations in the price-to-earnings(P/E) ratio. Bogle shows with historical data how, over a period of 120 years or so, total dividends plus the rate of earnings growth, plus the variation in the market P/E accounted for 100% of equity returns. His numbers were bang on. In the following paragraphs, we will show how we can use that same framework to acquire a solid understandfing of what the future may have in store for us, and how we can develop reasonable or likely expectations of what future equity returns will be.

Of the three components, dividends are the most predictable and the least uncertain. Currently, the average yield on S&P 500 stocks is roughly 2%, and for the S&P/TSX composite, 3%. We can predict, with a high degree of confidence, that dividends will growth in line with corporate earnings. For that, we will assume a growth rate of 5%.

The second component, i.e. earnings growth, is a bit more uncertain, yet fairly predictable over a 10-year period (and more so over longer periods). Historically, corporate earnings have grown at an average rate of 6-7%, depending on what period you choose. There have been boom years, in which earnings grew faster, and recession years, during which earnings growth was negative. However, in line with population growth, we can expect, with a good degree of confidence, that corporate earnings will keep growing in the long term, in line with economic growth.

It is believed that, in the long-term, developed economies should grow at an annual rate of 2-3%. However, corporations have the advantage of operating leverage. In other words, a 3% increase in sales will contribute more than 3% increase in earnings. Therefore, we can assume that corporate earnings will grow faster than GDP. Given the mature stage of our developed economies, and guided by more recent history, we will conservatively assume that earnings will grow by 5% over the next 10 years, and will contribute an equal percentage to equity.

By now, we have concluded that we can expect, with a fair degree of confidence, that added together, dividends (quite predictable) and earnings growth (reasonably predictable) would contribute to some 7% of annual equity returns over the next 10 years. As mentioned, this framework works only over long periods of time because the short term remains extremely unpredictable. Obviously, you or your advisor may have different views, or might want to use different assumptions of dividends and earnings growth, but the idea would be the same.

This leaves us with the third component, which is the least predictable:the (P/E) ratio. Today, the S&P 500 trailing P/E ratio, based on 2018 corporate earnings, is close to 18 times (we are using the trailing reported earnings for this exercise; you may have seen other ratios being referred to if operating and/or forward earnings are used. There is nothing wrong with that as long as the same ratio is used for consistency). In other words, for every one dollar of earnings, investors are prepared to pay $18. This is within the median range of fluctuations for this ratio since 1960, of 16 to 20 times. There have been years when it dropped below 10 times, and other years when it shot way above 25 times. Those are less common occurrences that tend to happen every 10 years or so, in other words not exactly rare. The only thing for sure is that, when the ratio sways out of the median range, it does revert back to it, in line with the universal principle of reversion to the mean.

Reversion to the mean can take years to happen, hence the famous quote by Benjamin Graham: "In the short run, the market is a voting machine, but in the long run, it is a weighing scale". Consequently, the P/E ratio, and with it equity returns, are very unpredictable in the short-term, but less so in in the long term.

P/E Ratio		Expected return
24		9.4%
22		8.6%
20		7.7%
18		6.7%
16		5.6%
15		5.1%
14		4.5%
12		3.1%
10		1.7%
8		0%

The above table summarizes what will be your average equity return on an S&P 500 index fund, in 10 years from now, depending on various possible P/E ratios at that time. If you apply the same method for Canadian equities, you would get roughly 1% p.a. higher for each outcome, given Canadian equities pay an average dividend yield of 3%. However, do take that with a grain of salt. The Canadian market's heavy concentration on financial and commodity-based equities makes it less predictable than a better diversified market such as the US. Moreover, earnings' forecasts of commodity based stocks, which represent nearly 30% of the S&P/TSX, are far less reliable, considering the sharp cyclicality of commodity prices.

The above table provides a reasonable range of expectations for future equiy returns. What actual market P/E will materialize 10 years from now, i.e what will be the actual market return, will depend on numerous factors, such as:

• What will be the actural earnings and dividends growth rate for the period. We have assumed a conservative 5% rate, which is lower than the historical average, given the mature stage of our economies. If the rate proves to be higher, so much the better.
• Where we will be in the corporate earnings cycle and what investors' expectations will be for the following couple of years.
• Where, at that time, we will be in the economic cycle: if we happen to be on an upward trend, and investors have high expectations, the multiple will be higher, and vice-versa.
• What will be the prevailing level of interest rates and at what stage of the monetary cycle we will be. If the economy is over-heating, and central banks are expected to raise interest rates, inverstors will pay less for one dollar of earnings, and vice versa.
• What major events will have taken place during the period or in the recent past. In the morning after a severe crisis, like the sub-prime mortgages one, investors' pessimism will be at its highest and the P/E multiple will be low. Likewise, the announcement of a massive fiscal stimulus will push investors to pay more for equities, and will bid P/E ratios and equity prices higher, similar to what happened in 2017.

The above list of influencing factors is nowhere near complete. The idea is to show how difficult it is to predict equity returns and the infinity of expected, or unexpected events, that can influence such returns. Hence the necessity to stay on top of developments and adjust expectations accordingly.

When we say that successful investors look forward, not only in the back mirror, the idea is not to pretend that we can see the future through a crystal ball and bet the farm on what we see. The point is that future outcomes depend on several events that are reasonably predictable in the long-term and very unpredictable in the short-term (the longer the term, the more predictable the outcome). To avoid nasty surprises, or being caught unprepared, one has to understand what are the possible outcomes to prepare for, and what is the probability of occurrence of each outcome.

Other things being equal, the most likely outcome is an equity return ranging between 5.6% p.a. and 7.7% p.a., compatible with a median P/E range of 16 to 20 times. Naturally, for the purpose of financial planning, you have to adjust this nominal return by inflation and investment costs. If, 10 years from now, investors remain prepared to pay for equities what they are paying today, i.e. 18 times earnings, annual returns will average 6.7%. For returns to exceed the upper side of the range (7.7%) by any significant margin, you will need some major positive factors to contribute to that, similar to the dot.com bubble, or extremely accomodating monetary policy (like another round of quantitative easing) or a major fiscal stimulus, suh as the massive corporate tax incentives introduced by the US Government in the recent past. Likewise, for an extremely negative scenario to prevail, you need a major crisis to happen, such as the sub-prime mortgage crisis.

The above table is intended to provide a broad framework for planning your financial affairs. If your financial/retirement plan is based on agressive equity returns, it might be wise to discuss it with your advisor, with a view to revise your plan and rebase it on something more reasonable, depending on your personal circumstances. As we always say, be ready for the worst and hope for the best. However, the key thing is not to panic or rush into doing something drastic. Adjustments do not happen overnight, and there is plenty of time to catch up.

January 22, 2019

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