The decade ending in 2023 was a great one for common stocks. Is the next decade likely to be as good? We provide an analysis using Damodaran's equity risk premium (ERP) and a framework developed by Jordan Brooks of AQR.
Hello and welcome back to 'Reflections on Investing' with the Cornell Capital Group. This is our first reflections of 2024, and, following the typical tradition, we thought we should look forward in light of what's come past. We don't like to do that on a yearly basis; we think on a yearly basis there's just too much noise in stock prices. Sentiment and psychology can have such an impact that analytical valuation, which we focus on here at the Cornell Capital Group, tends to get lost in the noise. But, over longer periods of time, say a decade, valuation comes to the fore.
So, what we're going to forecast is not the average return for next year or the expected return for next year, but for the next decade. And we're going to follow Jordan Brooks of AQR, the hedge fund, who's written a paper on this. We're going to follow his approach. And what he looks at is what's called the excess of cash stock return. In other words, what do stock returns over cash? And the two sides of that equation are the real return on common stocks minus the real return on cash. So that's what we're going to be looking at.
And if you go to our first exhibit here, this is a way to decompose that excess return on stock into the four central components: the dividend yield, the real stock growth, the expansion or contraction in the multiple (the price-earnings multiple), and finally the real return on cash itself.
So, if we go back to the prior decade, the decade ending December 31, 2003, it was a remarkably good decade. The excess of cash return on stock was 11.9%, making it one of the best decades in history. And here's how that broke down, and these numbers come from Dr. Brooks: The dividend yield averaged over the decade 2.1%. The real growth in earnings was 4.5%, which is actually a good deal above the very long run historical average. Earnings growth in the past decade was robust, but this dividend yield and earnings growth picked up a tailwind in the form of expansion of the price-earnings multiples. The multiple ended the decade well above where it started, and that translated into a 3.6% per year increase in stock prices. And finally, the real return on stocks, which we're supposed to subtract out—excuse me, on cash, which we're supposed to subtract out—was minus 1.7%. In other words, cash instruments like treasury bills and commercial paper had a negative return after adjusting for inflation. So, we're subtracting a number that is negative. Two negatives make a positive, and the negative return on cash balances translated into a 1.77% addition to the excess of cash returns on stock. You add all of these up, and you get a decade with an 11.9% excess return.
So, the question is, what do we think going forward is a reasonable projection for the excess return? And that's what's showing on our second chart here. First, the dividend yield: it's 1.5% as opposed to an average of 2.1% from the prior decade, because we're starting from a higher level of stock prices. Remember, the dividend yield is the dividends paid divided by the stock price. If stock prices start high, dividend yields are lower. For the real earnings growth, we take 2.9%, which is about average long-term, and we see no reason to believe that the next decade is going to be extraordinarily good or bad, so we'll stick with the average of 2.9%. What about the earnings multiple? We use zero. And I'm going to come back to this in a minute, but the earnings multiple is not something you can expect to keep growing and growing and growing. Eventually, it's got to stop. We think it's going to stop this next decade, so we put in zero for the effect of the earnings multiple expansion. And finally, the negative real interest rates of the last decade no longer seem to apply. As Howard Marks has noted in his recent memos, the last decade was characterized by extraordinarily low interest rates, something that we cannot expect to continue. The Federal Reserve projects inflation of about 2% going forward, and short-term cash interest rates of two and a half, that translates into about a half a percent real return on cash. And that's what we'll use.
So, if you add all these up, you get 3.9% per year, which is the Cornell Capital Group's expectation for stocks as a whole during the next decade. So, it's a good deal less than the last decade, and we urge investors to adjust their expectations and perhaps spend more time looking for specific opportunities because the rising tide that lifted everyone last decade is not likely to continue.
And finally, I want to say one more thing about why we don't think the multiple can continue to expand. Perhaps the most important driver of the multiple is the equity risk premium. It's the amount that investors require to hold stocks instead of government bonds—the amount of added expected returns. And this final chart, taken from my colleague Professor Aswath Damodaran’s website, shows his estimate of this equity risk premium over the last couple of decades. And you can see that it's currently well below its average. If it were to return to its average, that would likely lead to a contraction of the multiples, further reducing the expected return below 3.9%. But to be fair and conservative, we just assume no more expansion, no contraction.
So, we wish you a Happy New Year, but we hope you temper it with reason because the forces that have been driving stocks ever higher in the last decade, in our view, have become exhausted. And the next decade ahead will be more trying. This has been 'Reflections on Investing' with the Cornell Capital Group. Thanks for joining us.