Everyone with a 401(k) has been impressed by the stock market’s run-up in recent years. Even adjusting for inflation, the S&P 500 is more than 20 percent higher than its peak in the 1990 stock bubble. Of course, the economy is nearly 40 percent larger, which makes the run-up somewhat less striking.
Nonetheless, the ratio of stock prices to corporate earnings is at unusually high levels. According to data from Nobel Laureate and economist Robert Shiller, the current ratio of the S&P 500 to corporate earnings is close to 25. That compares to a long-term average of less than 15.
The reason this matters is that as the price-to-earnings ratio rises, the dividend yield falls. Forty years ago, the dividend yield was well over 4.0 percent. It currently is just over 1.8 percent. This means that more of the return from stock depends on a rise in the stock price.
But if stocks rise just in step with the economy and profit growth (this assumes no further rise in profit shares), then capital gains are not going to be offsetting a weak dividend yield. Using the projections from the Congressional Budget Office (CBO), GDP is expected to grow at less than a 2.0 percent annual rate over the next decade. Add in a 1.8 percent dividend yield, and shareholders are looking at a real return of less than 3.8 percent.
That is considerably less than the stock returns that many investors seem to expect. Historically, real stock returns have averaged close to 7.0 percent. That has come down some in the last quarter century; if we take the period since the last peak in 2007, real returns have averaged just 5.6 percent annually. It is very difficult to see how returns, even this high, can be maintained going forward.
Stock prices could continue to outpace profit growth, but that would mean ever higher price-to-earnings ratios and ever lower dividend yields. If the market were to provide the same 5.6 percent return over the next decade, as it did since the…