Classic Bernstein 9 — The Stock Returns Fairy, Exposed

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Classic Bernstein 9 — The Stock Returns Fairy, Exposed

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PREFACE: This is the ninth in a series of posts highlighting the classic investing insights of William Bernstein from the 1990s and early 2000s. Many new Bogleheads have never been exposed to his early writings — and while the data sets used may seem antiquated, his portfolio concepts and novel analyses are still helpful to investors today, new and old alike.

Previous topics in the series: 1-Asset Allocation & Time Horizon, 2-Choosing Portfolio Bond Duration, 3-Diversifying Portfolio Equities, 4-Stocks Always Beat Bonds?, 5-What’s a Thing Worth?, 6-The Value Premium & Inflation, 7-The Great Fund Fee Mystery, 8-Is Credit Risk Ever Worth Taking?
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One of the biggest areas of confusion for novice investors is just where stock returns come from. The most popular misconception is that future stock returns somehow derive from past stock returns — that is, from the Stock Returns Fairy. The fallacy of this approach is obvious: If you pay twice as much for an asset than you should have, that increases the returns of the person who sold it to you, just as surely as it reduces your future return. So just where do stock returns actually come from?

Dividends & Market Multiple. In this analysis, Mr. Bernstein first asks us: How much would you be willing to pay for a business that distributes $10,000 each and every year. Let’s say you arrive at a figure of $200,000. You’ve just determined that the annual return on your investment will be 5% ($10,000/$200,000). This is the same as saying you’re valuing the income stream of that business at 20 times its annual income. This is its market multiple and what determines the value of your business on a day-to-day basis. If tomorrow the market decides your business is only worth 15 times its income (which is still $10,000 per year), you have lost 25% of your investment value. However, over the long term, the fundamental increases in stock prices come from one source only: increases in earnings/dividend income (chart below).
  • Image
    Note: Post-1930s, the increased growth rates are due to higher inflation.
    Source: William Bernstein, Efficient Frontier (4/03)
As this chart shows clearly, the value of the stock market has almost exactly tracked the earnings and dividends it produces. In short, it behaves just like any other business.

Earnings Growth. Next, Mr. Bernstein asks us to assume that the earnings of our business are growing at the rate of 5% per year. If the market multiple remains at 20 times the income of the business, then so too will the market value of our business also increase by 5% per year. In other words, since next year our business will be earning $10,500, it will be worth 20 times that, or $210,000. If the market multiple remains the same, our return will be the sum of the income rate (5%) and the growth rate (5%), or 10% per year. Putting it all together, he offers this simple formula:
  • Image
The first two terms are easy to understand. A company that yields no income but grows at 10% per year, and one that yields a 10% dividend but does not grow, are equivalent. They’re also the same as a company with a 2% dividend and 8% growth, or an 8% dividend and 2% growth, and so on. The wild card in this equation is the change in market multiple, which can experience swings of 25% in either direction over the course of a year, swamping our 10% expected return.

What final conclusions does Mr. Bernstein draw from this analysis?
  • a) On any given day, the change in market price is caused almost entirely by the change in market multiple.

    b) Over long holding periods though, the stock market’s dividend yield and earnings/dividend growth will determine its return. In other words, the market’s fundamental return overwhelms the fluctuations in its market multiple over time.

    c) The long-term, expected return of the stock market is simply the sum of its dividend yield (say 2%), plus its earnings/dividend growth rate (say 4.5%), for a nominal return of 6.5% — assuming no change in market multiple.
Thoughts?
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

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To represent Mr. Bernstein’s stock returns formula in visual form, this chart does a good job:
Dividends (in yellow), plus earnings-per-share growth (in green) make up the fundamental return of the stock market, around which the speculative return, or change in market multiple (in pink), fluctuates both positively and negatively. The key point is that the speculative return always reverts back to the level of the fundamental return over long holding periods — irrational exuberance and pessimism do not endure!
FCM
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by FCM »

Simplegift, the chart showing the decomposition of the S&P500 is an excellent depiction of where equity returns come from. It's so easy to comprehend. Well done!
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by qwertyjazz »

Thank you - you truly have a gift for making the complex simple

On the link for the chart - it is interesting to note the comment of how this is a long term trend - the BI article has the key point that it can be longer than the investment horizon of an individual

I keep struggling with Keynes lines of in the long run we are all dead, deep risk of relative simple index fund companies over a significant time frame and market having possible fundemental truths. But we may be dead and even Vanguard may have changed its investing approach ...
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

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qwertyjazz wrote:In the link for the chart - it is interesting to note the comment of how this is a long term trend - the BI article has the key point that it can be longer than the investment horizon of an individual...
Right. Even over 50-year holding periods, the speculative return of the stock market does not always exactly equal zero in practice. The chart below shows the annualized changes in the market multiple (PE10) over rolling 30- and 50-year periods, 1881-2013.
To interpret this chart: For the 50-year period ending in 1950, for example, the PE10 multiple change (in green) averaged plus 2% per year over that period. For the 50-year period ending in 1980, the multiple change averaged minus 1% per year — and so on.

Thus even if one holds stocks for 50 years, one can't completely escape the effects of the speculative return and long-term PE multiple changes. Fortunately for investors during the past century, these long-term PE changes have been mostly positive — but there's no guarantee that they'll be so in the decades to come.
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by galeno »

Excellent. Kudos. Thank you.
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by siamond »

Simplegift wrote:What final conclusions does Mr. Bernstein draw from this analysis?
  • a) On any given day, the change in market price is caused almost entirely by the change in market multiple.

    b) Over long holding periods though, the stock market’s dividend yield and earnings/dividend growth will determine its return. In other words, the market’s fundamental return overwhelms the fluctuations in its market multiple over time.

    c) The long-term, expected return of the stock market is simply the sum of its dividend yield (say 2%), plus its earnings/dividend growth rate (say 4.5%), for a nominal return of 6.5% — assuming no change in market multiple.
Thoughts?
This type of formula can actually be derived from the simple truth that total-returns = dividends + price-change. Introducing a given valuation metric (e.g. earnings) in the formula, and doing some algebra, you easily end up with a 3-factor formula as described in the first post. So this type of formula isn't a nice theory, it is a hard fact.

Where there is some confusion (notably in the writings of Dr Bernstein, I'm afraid) is to mix up dividends and earnings in the 2nd and 3rd factors. Using dividends growth and Price/Earnings would BREAK the algebra. So one should either use earnings-growth and P/E, or dividends-growth and P/D. Or, more subtle, E10 growth and P/E10. In the past, dividends growth and earnings growth (or E10 growth) weren't that different, so it didn't matter, but in more recent times, with buybacks, this all changed a lot, and this confusion is clearly a significant source of errors, notably when such formula is used to estimate expected returns.
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

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siamond wrote:So one should either use earnings-growth and P/E, or dividends-growth and P/D. Or, more subtle, E10 growth and P/E10. In the past, dividends growth and earnings growth (or E10 growth) weren't that different, so it didn't matter, but in more recent times, with buybacks, this all changed a lot, and this confusion is clearly a significant source of errors, notably when such formula is used to estimate expected returns.
A helpful clarification and reminder, siamond. Thank you.
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by siamond »

Simplegift wrote:What final conclusions does Mr. Bernstein draw from this analysis?
  • a) On any given day, the change in market price is caused almost entirely by the change in market multiple.

    b) Over long holding periods though, the stock market’s dividend yield and earnings/dividend growth will determine its return. In other words, the market’s fundamental return overwhelms the fluctuations in its market multiple over time.

    c) The long-term, expected return of the stock market is simply the sum of its dividend yield (say 2%), plus its earnings/dividend growth rate (say 4.5%), for a nominal return of 6.5% — assuming no change in market multiple.
Thoughts?
One has to be careful with what 'long-term' means. I did my share of backtesting with expected returns formulas like this one, and it became quite clear that the change in market price remains a VERY significant driver for a full decade, if not two. And sometimes even more. And well, after 20 to 30 years, other assumptions will change (no clue what will happen to dividends by then!). So, although I agree with those conclusions, for all practical purposes, I'd strongly suggest to use this equation with the three factors (like Mr Bogle does, although in a bit of a peculiar way). And then, the devil is in the details! :twisted:
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by qwertyjazz »

How do amount of buybacks compare to options and other share creations now?
Are we still met gaining in shares?

https://www.researchaffiliates.com/Prod ... lution.pdf
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by Bill Bernstein »

Yes, we're still diluting, but more slowly, perhaps the "new normal" is more like 1%, not 2%. (Rob keeps these data, and it's been a bit since I've peeked, but that was my eyeball of it last I did.)

What this tells me is not to worry too much about economic slowing harming stock returns. Yes, Virginia, long-term (real) economic growth may be more like 2%, not the historical 3%. But dilution is also off by 1%, so no harm, no foul.

Another way to to put this is that the economy is growing more slowly, and so needs to raise less fresh capital with which to dilute existing shareholders.


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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by GreatOdinsRaven »

I've always liked this graph from Jack Bogle's, Common Sense on Mutual Funds. It charts the fundamental and market returns (which includes the speculative return/change in P/E retio). We see that in the short term changes in the P/E ratio affect actual returns, but over time the market return closely tracks the fundamental return. This is basically repeating what's already been posted.

* I think sharing it falls under fair use. If not, please alert me and I will immediately withdraw the image.

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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

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Another way of using the historical record to test the relationship between fundamental and speculative returns is to employ Mr. Bernstein’s expected stock return formula in the OP (a version of the Gordon discounted dividend model), and then see what the actual return was 30 years later. The only published study I know that’s looked at this was by Foerster and Sapp 2006, which used the Shiller database for backtesting:
When interviewed and asked if the model had predictive power, Dr. Foerster replied, “On the whole it does. The deviations are consistent with times when investors are either overly optimistic or pessimistic.”
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by AlohaJoe »

Bogle has a very similar take on returns, which he recently updated (with a co-author) a few months ago. The paper was published in the Journal of Portfolio Management: http://www.iijournals.com/doi/pdfplus/1 ... 5.42.1.119
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by GreatOdinsRaven »

AlohaJoe wrote:Bogle has a very similar take on returns, which he recently updated (with a co-author) a few months ago. The paper was published in the Journal of Portfolio Management: http://www.iijournals.com/doi/pdfplus/1 ... 5.42.1.119
Thank you for sharing this paper! Looking forward to the read.
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by TomCat96 »

Thank you, this was an excellent post.

I love how it explains reversion to the mean. It looks like the dividend return is the fundamental baseline around which the peaks and troughs of the speculative return gyrate. Therefore, the stock market cannot go too far beyond the fundamental return before reverting back to that baseline.

The dividend return does drive the fundamental return of the stock market. The problem is the function is so ridiculously long based relative to our lifetimes that equipping yourself with generalizations about market behavior is nigh useless for day to day trading, and really only shows utility when incorporated as part of a long buy and hold strategy.
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Re: Classic Bernstein 9 — The Stock Returns Fairy, Exposed

Post by LadyGeek »

A complete list of Simplegift's series is in the wiki: Classic Bernstein
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