Without the math skills to reproduce Mr. Livermore’s expected 4% real return at a CAPE range of 25-30, I’ll need to take his word for it. I do share his view that U.S. stock valuations are likely to stay high for years — due to increased investor participation, low-returning alternatives and interest rates, less perceived risk — but this is the first suggestion I’ve seen that the expensiveness of the market itself (and not mean-reversion) could lead to lower future returns.J. Livermore wrote:The mechanism for the lower returns, in my view, is not going to be some kind of sustained mean-reversion to old-school valuations, as the more bearishly inclined would predict. Rather, it’s going to come directly from the market’s expensiveness itself, from the fact that dividend reinvestments, buybacks and acquisitions will all be taking place at much higher prices than they did in the past. On the assumption that current valuations hold, I estimate that long-term future returns will be no more than 4% real.
To get that number, I recalculate the market’s historical prices based on what they would have been if the market had always traded at its current valuation — a CAPE range of 25 to 30. With the dividends reinvested at those higher prices, I then calculate what the historical returns would have been. The answer: 4% real, reflecting the impact of the more expensive reinvestment, which leads to fewer new shares purchased, less compounding, and a lower long-term return.
Does this way of thinking about expected returns make sense? Any math experts that can model this effect?