Stocks attractive for long-term

Marvin Appel, MD., PhD & Brian Hufford, CPA, CFP

The question on many investors' minds is whether stocks will ever again be good investments. And, if the stock market does improve (and we expect it will in 2003), how much can you expect to earn over the long term? This month's column presents some of our forecasts based on principles we've observed over time.

1 Stock prices have grown in line with earnings growth. From the 1920s through 1990, stock prices (S&P 500 Index) tracked earnings growth. The only exceptions were periods when corporate earnings grew before stock prices caught up. However, in the 1990s, for the first time, stock prices got ahead of earnings.

During the past three years, stock prices have retreated, but so have corporate earnings. The relationship between the S&P 500 Index and the earnings of its component companies is about average, but only when current low interest rates are taken into account. The implication: stocks are now neither great bargains nor wildly overpriced, but they have the potential to start rising — as long as there is no recession.

2 Corporate profits are unlikely to outpace growth in the economy over the long term. Since 1947, the overall profits of large, publicly traded U.S. companies (S&P 500 earnings) have grown at 5.9 percent per year. Inflation over that period has been 3.9 percent per year. The difference between profit growth and inflation is called the real rate of earnings growth. Since 1947, corporate profits have grown at an average of 2 percent per year above inflation, while the real rate of economic growth has been 3.3 percent per year over inflation.

Current economic forecasts predict that the economy will grow about 2.5 percent above inflation during 2003. There is no reason to expect the economy to grow more rapidly in the next 10 to 20 years than it did during the past 50.

The implication of the first two principles is that over the long term, investors might reasonably project stock prices to grow 2.5 percent per year above inflation.

3 Total return to investors is stock price growth plus dividend payouts. The S&P 500 currently pays just under 2 percent per year in dividends. Adding this yield to the expected long-term price appreciation of 2.5 percent results in expected stock market total returns of 4.5 percent per year above inflation.

The 4.5 percent per year figure is lower than the long-term historical return of more than 7 percent above inflation each year that stocks have returned since 1926. However, 4.5 percent per year over inflation is far higher than the long-term, historical rates of return of many other types of investments.

From 1984 to 2001, companies repurchased significant amounts of their own stock. Such share buybacks have now stopped because companies are no longer profitable enough to devote their available cash to such endeavors. If share buybacks resume, the total return to shareholders would likely be higher than 4.5 percent per year above inflation.

Planning for the long-term

Investment returns are likely to be more modest in the coming decade. We advise long-term investors to assume that their stock investments will return no more than 4.5 percent per year over inflation.

In an era of moderate returns, low-cost mutual fund investments becomes particularly important. We recommend the Vanguard S&P 500 Index Fund (ticker VFINX) as a core stock holding. It has a large asset base, low expenses, and no cost per transaction.)

Historically, small company stocks have returned about 1 percent per year more than large company stocks. They do have a greater risk; however, investors looking for a low-cost investment in small company stocks in an attempt to capture a higher return should consider the StreetTracks Small Cap Value exchange-traded fund, ticker DSV.

Next month's column will address the potential limitations on future returns from bond investments.