The Long Term Stock Market Return Factors

In his latest book Common Sense on Mutual Funds (Fully Updated 10th Anniversary Edition) John Bogle publishes a remarkable table.

He posts ten year nominal stock market returns for 1927 to 2009.

Then he posts the total (for the same periods) of the initial dividend yield, the annual earning growth (of operating income) and the change in the Price/Earnings ratio (P/E ratio).

If you add the initial dividend yield to the average earning growth and then add that to the change in the P/E ratio, the total almost exactly matches the real total return for the period.

Now, two-thirds of that makes common sense. Part of the total return is dividends, so there they are. And the change in P/E is a measure of the stock market's changes in sentiment.

But the annual earnings growth of the company is not usually factored in.

So Bogle's conclusion from the table is that the long term stock market results come from the fundamentals of dividends paid to investors and a company's annual earnings growth -- not from what he calls "speculation," the tendency of investors to buy a stock on the hope a greater fool with raise the price.

However, the more I think about it, the more I have to disagree with him, reluctant as I am.

These factors are more interrelated than he describes, because the P/E ratio -- obviously contains the company's earnings. Thus, these factors are interrelated.

The change in P/E is a measure of the overall market sentiment regarding that company. A high P/E means that the market began the period giving the company a high value.

In the following ten years, the company's earning grew at their average rate. If the market's sentiment turned negative, then the closing P/E ratio will be lower, and this will reduce the overall return.

Sometimes the reverse will be true. The "speculation" is still there -- embedded in the change of P/E ratio.

The general conclusion is that it's better to buy a stock when the P/E is low than when it's high, but that's scarcely a new revelation. Value investors have said that since at least Ben Graham.

The only way to escape from the tyranny of the P/E ratio and market sentiment (which can change a lot no matter whether the company's fundamentals do), is to invest only in stocks that pay a dividend.

That way, you receive a real, spendable cash return no matter what happens to the P/E ratio.

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