With the stock market still near 12-year lows, investors have to be wondering what the future will hold for stocks purchased at today's prices.
When it comes to determining investment returns, past is never prologue. It's foolish (small "f") to think the next decade will be as bad as the past one -- or as good as any other before it. Markets and economies, after all, constantly change.
Maybe the next change will take the form of a significant technological advance, like the Internet was for the late '90s, ushering in new business platforms like Amazon.com (NASDAQ:AMZN) and eBay (NASDAQ:EBAY). Maybe it will involve unexpected geopolitical events, or the introduction of new investment instruments like the exchange-traded fund, or a secular shift in the perception of equities as an asset class.
We just don't know what will happen next in the market. But with Wall Street in tatters and under scrutiny, here's what I predict for the next decade: little financial innovation and once-bitten, twice-shy investors.
What does that mean?
That means two things:
- Less trading.
- Less risk-taking.
Following the Great Depression, turnover on the NYSE fell from a then-high of 143% in 1928 (100% turnover means the average stock was held for less than a year) to below 20% by 1938. It remained below 20% for nearly four decades. Chalk it up to apathy after being burned by the Depression, or more patience following the stresses of World War II, but investors were simply less engaged in the equity market for about 30 years after the war ended.
It wasn't until the late 1970s, when institutional investors like mutual funds, hedge funds, and endowment funds grew in prominence, that turnover began sustained growth, peaking at 215% in 2007. Though singed themselves, these large investors will continue to be part of the mix, so there's little chance that trading volumes will fall below 20% again -- but after the panic of the last 18 months, a return of some degree of investor aversion to equities does seem likely.
And those investors who stay in the market will likely seek less risk now that they've been similarly burned. Since the market began to fall in October 2007, for instance, some $290 billion has been pulled out of stock-based mutual funds and $90 billion has been reallocated to bond funds.
Along those lines, I don't expect investors to be as quick to chase volatile, non-dividend-paying growth stocks such as NVIDIA (NASDAQ:NVDA) and First Solar (NASDAQ:FSLR) as they will be to seek lower-volatility, dividend-paying larger companies like Procter & Gamble (NYSE:PG) and Automatic Data Processing (NYSE:ADP). The highfliers will continue to profit, sure, but the P/E ratios assigned to growth stocks may not soar as high as they once did.
Um, so what?
Less trading and less risk-taking matter because, in the long run, stock returns roughly equal investment return (earnings growth + dividend yield) plus speculative return (the multiple investors are willing to pay for a dollar of earnings).
As Vanguard founder Jack Bogle explained in a 2006 speech:
For example, a 4 percent initial yield plus future earnings growth of 6 percent would equal a 10 percent investment return. If the P/E were unchanged over the decade, the total return would be 10 percent. If the P/E rose, say, from 15 to 20, that 33 percent gain, spread over a decade, it would add almost 3 percent per year to the return, increasing it to 13 percent. If it were to decline to 12, it would reduce the returns by more than 2 percent. Yes, it is that simple.
In other words, even if companies reliably grow earnings over the next decade, you also need to consider what price investors will be willing to pay for those earnings. If they're as greedy as they have been for the past decade and put a high price on those earnings, the future returns will be augmented. Conversely, if investors are as fearful as they were in previous economic downturns, future returns could be muted.
How you can profit
So as you're thinking about the future of the market -- and your portfolio -- remember that it's not just earnings growth and dividend yield that matter. Investor attitudes and risk tolerance can either magnify or shrink the investment returns of enterprises -- and you have to consider them as you develop a market outlook.
In times like this, as investors are rethinking their relationship to the market after being burned twice in one decade, it pays to be conservative with your estimates and valuations.
But this market is also providing great opportunities -- strong companies trading at very compelling values. Consider 3M (NYSE:MMM), which is trading for just over 10 times free cash flow, recently increased its dividend payout, and yields 4%. Since it's already attractively priced, as long as 3M can grow its earnings at a reasonable rate over the next 10 years and at least maintain its current dividend payout, the long-term gain potential of the stock is considerable, whether or not investors remain gloomy about the overall market.
These are just a few reasons why our Motley Fool Inside Value team named 3M a "Best Buy Now" in its March newsletter. If you'd like to learn more about other stocks our Inside Value team is recommending in this market, your free 30-day trial of the service is on us. Just click here to get started.
Todd Wenning wonders if his Cincinnati Bengals can put together a winning season this year, but isn't getting his hopes up. He owns shares of Procter & Gamble, but of no other company mentioned. Procter & Gamble is a Motley Fool Income Investor recommendation. eBay and 3M are Inside Value recommendations. Amazon.com, eBay, and NVIDIA are Stock Advisor recommendations. The Fool owns shares of Procter & Gamble and has a disclosure policy.
