VOL. 1, No. 4

Real Returns Report
FEBRUARY 13, 2012

Contents This Week 10% Stock Returns: Myth and Reality Value Map

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Contents From the Archives License/ Disclaimer

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This Week
Adding U.S. small-caps to our coverage I'm adding the small-capitalization segment to our coverage, beginning with the P/E10 for the Russell 2000 Index (we're still seeking some data in order add the Equity q ratio.) With a current P/E10 value of 32.0, I don't find these small-caps in any way enticing. Indeed, here are a couple of benchmarks for that figure:  At the end of June 2007, the index stood at 833.70, the P/E10 was 36.80 – only 15% higher than it is today. No need to rehash stocks' performance since then. As of the end of 2011, with the index at 840.92 (P/E10: 29.4), fund manager GMO's forecast real return for U.S. small-cap stocks over the next seven years was negative 0.5% per annum.1 The segment is now 10% more expensive.

We cannot recommend buying this segment at this time; in fact, we urge investors who have not already done so to consider trimming their allocation to underweight. [Reminder: This advice need not apply to stock-pickers who have selected the small-caps they own individually, on a bottom-up basis.]

Interview with The Economist

Part one of my interview with Philip Coggan, financial markets columnist for The Economist (aka 'Buttonwood') ran last week on The Motley Fool (The U.S. and China: A duel to


GMO 7-year Asset Class Return Forecast as of December 31, 2011. Page | 1

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the debt, Feb. 8). If you haven't read it, I urge you to do so as it's highly relevant to any investor who takes macro issues seriously (nowadays, that should be every investor, period.) Part two of the interview will be published today; I'll post a link on the blog. Buttonwood's new book, Paper Promises: Debt, Money, and the New World Order, was released in the U.S. a week ago. The book looks at the relationship between debt and money starting
in Antiquity through the credit crisis; I highly recommend it.  1

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The Enduring Myths Surrounding U.S. Stock Returns
It has become received wisdom that one can expect a 10%-11% average annual return over the long term by investing in U.S. stocks. Where does that figure come from and is it relevant in the current market? As far as I can tell, the most widely cited paper regarding long-term U.S. stock returns and the equity risk premium is Long-Run Stock Returns: Participating in the Real Economy by Ibbotson and Chen (I'll refer to the authors as 'IC' in the rest of the article.) It's a very useful paper, no doubt about it, but one is ill-served by trying to sum it up in a single figure. The four components of stock returns IC calculated the average annual return on stocks between 1926 and 2000, which they put at 10.7%, before proceeding to break that figure down through six different methods. The method I'm concerned with today is the earnings method, which deconstructs stock returns into 4 building blocks:     Inflation (CPI) Inflation-adjusted earnings growth, or g(REPS) Growth in the price-to-earnings ratio Income

If you don't find this decomposition intuitive, think of it this way: A stock investor earns returns from two sources, dividends and capital gains. The former correspond to the fourth item on our list ('Income'). Capital gains, on the other hand, correspond to stock price appreciation (or depreciation!), which price can be expressed as: Price = (Earnings-per-share) x (Price-to-earnings ratio) (All we've done is re-arrange the expression that defines the P/E ratio: If the P/E is equal to the stock price divided by the earnings-per-share (EPS), then the price must equal the P/E ratio times the earnings-per-share.) Capital gains – stock price changes -- are then attributable to earnings growth and changes in the P/E ratio. The last step is to break out inflation and to isolate real earnings growth and we've now got the four components we enumerated above.

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Once IC ran the numbers, this is how things shook out: Contribution Inflation Real earnings growth P/E ratio growth Income Historical equity return (1926-2000)
Source: Ibbotson & Chen (2002)

3.08% 1.75% 1.25% 4.28% 10.70%2

(On the following page, you'll find the same results in graphic form.) The table indicates that multiple expansion (i.e., growth in the P/E multiple) accounts for one-and-a-quarter percentage points in annualized return. Or, as IC observe: P/E increases account for only 1.25 pps of the 10.70 percent total equity return. The use of 'only' here is surprising when one considers that P/E expansion is, together with real earnings growth, the most volatile total return component. It's also the only component that can take on negative values, thus detracting from returns. In any event, using P/E ratios calculated on 12-month earnings muddies the waters when it comes to isolating the effect of genuine changes in risk aversion. An extreme example illustrates the problem: In December 1932, when stocks' P/E reached 132.50, did it indicate that stocks were massively overpriced? No, it simple reflected the collapse in corporate earnings during the Great Depression. It's absolutely true that, all other things equal, the longer the time period, the smaller the impact of changes in the P/E multiple on total returns. Nevertheless, due to its volatility, this effect is not to be mis-underestimated. Next week, I'll look at a different decomposition method to analyze returns -an earnings-based method that uses a more stable indicator. Once we're able to get a look at "clean" historical numbers for

Perspicacious readers will have noticed that the components do not sum to 10.70%. This is due to the fact that I omitted a fifth component, equal to 0.20%, which corresponds to the reinvestment return and a geometric interaction between the different components (10.70% is the geometric, not arithmetic, average return.) Page | 4

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each component, it'll be easier to make a few assumptions in order to estimate the returns investors can reasonably expect from this point forward. Next week: Look for the second part of our discussion concerning expected stock returns.  1

Source: Ibbotson & Chen (2002)

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Value Map
INDIA - Broad market/ Large-cap stocks
% Above (below) geometric average

Feb. 10, 2012

Current value (02/10) SENSEX Index Equity q ratio P/E10 BSE-100 Index Equity q ratio P/E10 S&P CNX Nifty Index Equity q ratio P/E10* 1.02 21.1 1.07 20.6 1.04 21.3

Percentile rank

% Above (below) arithmetic average

Standard deviation

42% 41%

(5%) (7%)

(10%) (13%)

0.38 8.6

50% 36%

(0%) (11%)

(5%) (15%)

0.37 7.9

54% 25%

2% (12%)

(3%) (13%)

0.32 3.2

*This item is not meaningful as the history is simply too short. Source: BSE Ltd., MOSPI, The Real Returns Report

U.S. - Broad market/ Large-cap/ Small-cap stocks
Current value (02/10) Equity q ratio, Aggregate U.S. equities S&P 500 Equity q ratio S&P 500 P/E10 Russell 2000 P/E10 Series length Percentile rank % Above (below) geometric mean % Above (below) arithmetic mean Standard deviation


1945 – 2012






1871 – 2012





21.4 32.0

1871 – 2012 1993 - 2012

83% 50%

41% 6%

30% 5%

6.6 5.1

Source: Federal Reserve Board of Governors, Robert Shiller, Standard & Poor's, The Real Returns Report

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Notes Equity q = Market value / Net worth (estimated at market prices)

The Real Returns Report

This is a variation on Tobin's q. When it is calculated over all U.S. equities, it is a quarterly series since it depends on data from the Federal Reserve's Flow of Funds report. However, it's possible to calculate the ratio mid-quarter, as I have done, by adjusting the market value to reflect changes in equity market indexes. Here, I used the Wilshire 5000 full capitalization index, which is the broadest measure of U.S. equities' market capitalization and performance. P/E10: Also known as the cyclically-adjusted PE (CAPE) or "Shiller PE" after Robert Shiller of Yale. The P/E10 uses the average of the prior ten years' earnings, on an inflation adjusted basis, as its earnings input. The rationale behind this is the observation that earnings are too volatile on a year-to-year basis to provide reliable information on a company's (or a market's) true earnings power. By using a ten-year average, the P/E10 smoothes out earnings volatility and allows investors to better identify legitimate changes in risk premiums. The figures in this table are derived from Professor Shiller's data (available from his web page), which include series of monthly average prices for the S&P 500/ S&P Composite Index.

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From the Archives: Seller's Remorse

Broker (to wealthy but stingy client): Client: Broker: Client:

"Glad you did so well with those shares I told you to buy." "Why, I lost a pot of money over them." "What? You bought at two and sold at seven, didn't you?" "Ay! But they went up to ten after!

Note the use of 'ay' by the client in his retort to his broker, which suggests that he is Scottish. Indeed, among the English, the Scots have a reputation – probably unjustified – for being stingy.  1

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The Real Returns Report by Alex Dumortier is licensed under a Creative Commons AttributionNonCommercial-NoDerivs 3.0 Unported License. Permissions beyond the scope of this license may be available at

Disclaimer: This research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. This research does not constitute a personal recommendation. The price and value of the investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors.
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