Mellon (The Practice of Wealth Management)

Investment Update (December 2004)

COMMON STOCKS EXPECTED RETURN

Over a year has passed since the Update focused on return expectations for stocks. This Update will concentrate on our expectations for the eight‑year period beginning 2005 through 2012, while January's Update will outline the environment confronting financial assets in 2005. Please keep in mind that the margin of error in speculating about stock returns over a relatively short timeframe is large. The confidence level would be enhanced greatly with a forecasting period of 50 years, but this would be of little use for the planning needs of individuals and funds.

The building blocks for assessing prospective US common stock returns are the income yield, the annualized growth in profits and any change in valuation. This Update presents these building blocks in a component‑by‑component format that allows readers to modify any of the factors should they have an opinion that differs from ours. It also provides a convenient way to compare our expectations with other opinions.

Dividend yield The present yield on the Standard & Poor's 500 Index is 1.6%. This low beginning yield will be a drag on future stock returns. Dividend yields have been extraordinarily low since the late 1990s, due to a combination of unusually low payouts of profits and relatively high stock valuations. Payouts have been low because corporations correctly believed that it was more tax efficient to reduce the percentage of profits paid out to shareholders, since dividends were taxed at a higher rate than capital gains. The retained cash could be spent to buy back outstanding shares.

The new, lower tax rate on dividends is encouraging corporations to increase their payouts to shareholders. Additionally, companies are flush with cash, due to the spurt in profits and tepid capital expenditures. Dividends for the S&P 500, which have increased 19% over the past two years, should grow more rapidly than earnings over the next few years. We believe that an increasing payout will allow dividend yields to contribute 2.2% to future stock returns, rather than the present yield of 1.6%.

Profit growth Profit growth is a function of sales growth impacted either positively or negatively by any change in profit margins. Gross Domestic Product (GDP) growth can be thought of as sales growth for the total economy. Over the last 50 years, the GDP has grown at 7.0% annually. This growth is composed of both real and inflationary components. GDP price inflation has been 3.6% and real growth has been 3.3% annually, since 1954. The economy's real growth is a combination of increases in the labor force and improvements in labor's productivity. We expect real growth to trend between 3% and 3.5% over the next eight years, which is consistent with historical increases.

The very loose US monetary policies and declining value of the dollar likely will boost inflation from the low levels of the past few years, when global deflationary pressures were most severe. Our range on inflation for the next eight years is 2.5% to 3.0%. The combination of the economy's real growth and inflation is expected to produce both GDP and corporate sales growth of between 5.5% and 6.5% annually.

Profit increases have matched sales growth over the long term. For example, over the last 50 years GDI which is a measure of sales, has grown at 7.0% per year, while corporate profits after taxes, using the government's comprehensive tabulation of all public and private companies, also have increased at 7.0%. Over short periods of time, changes in profit margins may result in sales and profits growth being vastly different. Obviously, profit margins fall during recessions and rise during periods of economic recovery. Also, labor or capital from time‑to‑time gains the upper hand in the ongoing struggle for shares of national income. Because of globalization, the competitive forces of foreign competition and outsourcing of jobs, labor's bargaining power is not as strong as has often been the case. Thus, profit margins presently are above average.

We do not believe that the remarkable leap in profit margins of the last couple of years can continue. As idle capacity is utilized, more workers will be required and wage growth will pick up, slowing productivity gains. Indeed, because margins in 2004 are above average, we believe the odds are low that profit growth will exceed sales increases over the next several years. Even though the forces of capitalism will cause a reversion of margins toward their longer‑term average, we estimate that margins will remain higher than normal over the next eight years. Our assumption is that profits will grow about one‑half percent less than sales, namely 5.0% to 6.0%.

Profit growth for the S&P 500, a semimanaged group of 500 mostly large companies, has not kept pace with overall corporate profits, which include all public and private corporations. As companies issue additional shares for new capital or for stock options, the resulting dilution prevents pershare growth from keeping pace with a company's dollar increase in profits. Also, the entrepreneurial capitalism of small companies, Google as an example, captures a share of the growth in overall corporate profits. We estimate that the S&P's profits will grow about one‑half percent slower than the government's measure of corporate profits. In summary, the growth factor is expected to contribute approximately 4.5% to 5.5% to the return on stocks over the next eight years. Table 1 displays the contribution of the various components of the growth equation both for the next eight years and historically.

TABLE 1 THE GROWTH
COMPONENT OF STOCK RETURNS
	Expected	Historical
	2005- 2012	Last 50 Years
Real GDP	3.0-3.5	3.3
+ GDP Inflation	2.5-3.0	3.6
= GDP	5.5-6.5	7.0
Corporate Profits
After-Tax	5.5-6.5	7.0
- Loss from Profit
Margin Decline	0.5	0.0
- Share dilution
to S&P 500	0.5	0.9
= S&P 500 Profit Growth	4.5 - 5.5	6.1

As shown in Table 2, stock dividend yields are projected to contribute 2.2% to total returns and profit growth will add another 4.5% to 5.5%. Therefore, absent any change in valuations, we would expect annual stock returns to compound at 6.7% to 7.7% over the next eight years.

Valuation change‑Estimating the prospective return on stocks requires an assumption about the price‑toearnings (PE) multiple at the end of the measurement period. If the PE multiple declines from the present level, then the total return will be less than implied by earnings growth and the dividends collected. If the valuation of profits increases, then the return will be enhanced. These valuation changes easily can dominate the yield and growth components of investment return. Also, valuations are subject to wide variation, depending on the investment climate at any given time. Our approach is to employ what we believe is a normal valuation with possible high and low bands around the average.

TABLE 2 BUILDING BLOCKS FOR STOCK RETURNS
	Historical	Expected	High PE	Low PE
	1926- 2003	2005- 2012	Scenario	Scenario
Dividend Yield	4.3	2.2	2.2	2.2
+ S&P Profit Growth	5.0	4.5-5.5	4.5-5.5	4.5-5.5
+/- valuation Change	1.0	-1.2	0.9	-3.7
= Total Return	10.4	5.5-6.5	7.6-8.6	3.0-4.0
Note: Expected PE Multiple	15.0	17.0	20.0	14.0

The S&P 500 has traded at a median PE multiple of 15 since the 1920s. We believe that the average expected PE should be higher than the historical. Clearly, the economy has been substantially more stable in the last 20 years than was the case 50 or 80 years ago. Additionally, stock market liquidity and regulation have improved over the years. These factors prompt us to raise the normalized PE multiple to 17. Stocks are selling at an above average 18.5 times the past 12 months' profits. Thus, if the PE regresses to the expected norm over the next eight years, the change in valuation will clip about 1.2% from the annual return on stocks. Other valuation methodologies confirm that stocks currently remain somewhat expensively valued.

Price‑to‑earnings multiples have varied widely, ranging from the exuberance of the late 1990s, when stocks traded at more than 25 times earnings, to the despondence of the early 1980s, when stocks sold at eight times profits. We would expect the terminal PE multiple to fall within a more narrow band than these extremes. Table 2 indicates the impact on expected returns if the PE multiple is 20 times or a below average 14 times at the end of eight years.

In summary, our estimate is for stocks to generate compounded total returns over the next eight years of about 6%. If valuations modestly increase from the present level, returns could be near 9%. If valuations fall to a below average level, the return may only reach 3% annually. Obviously, the stock market's yearly returns will vary substantially from the longer‑term expectation. The 6% return would provide a premium of only about two percentage points to the 4% yield available on Treasury bonds maturing in eight years. This is less than the traditional risk premium earned for investing in stocks. This suggests that maintaining allocation to bonds is appropriate, even though yields are low. The 6% expected return also compels broad diversification and attention to international investments.