What Is The Source Of Long-Term Stock Market Returns? (or… Do Stocks Really Always Go Up?)

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Why do we think that the stock market will always go up? Why has it gone up over long periods of time historically? For instance, let’s look at this graph:

There is one theory that I have read about in the writings of respected authors like Jack Bogle and William Bernstein. It states that there are three main components to long-term stock market performance:

Part 1: Dividend Yield
Obviously, if your stock distributes 2% in dividends each year, then you will have a 2% contribution towards of return.

Part 2: Earnings Growth
If earnings stay constant, then all other things equal, one would expect the share price of your company to stay constant as well. If the earnings grow by 5% every year, then your share price will grow by 5% per year. Thus, earnings growth rate is a vital component of total return.

These two parts added to together are coined the fundamental return:

Fundamental Return = Earnings Growth + Dividend Yield

Part 3: Changes in P/E Ratio
The price-to-earnings (P/E) ratio is the price per share divided by earnings per share. In other words, it is how much investors are willing to pay for each unit of earnings. If they are willing to pay 20 times annual earnings, the share price of the stock will be twice as high as if they only paid 10 times earnings. This part is denoted the speculative return, as it has changed throughout history:

Speculative Return = P/E Ratio Changes

Adding these two up finally gives you:

Total Return = Fundamental Return + Speculative Return

Predicting Fundamental Return
Now, what if your portfolio was all of the stocks traded in the United States? This would create a connection between the growth rate of the nation’s Gross Domestic Product and the earnings growth rates of all US companies. In other words, the fundamental return is based on GDP growth. In turn, the GDP growth rate is connected to population growth and productivity per person.

Here’s my quick take: If you invest in a globally diversified portfolio, do you believe that the world’s GDP will continue to increase in the future? I believe that this is a very good bet, and is a major reason why I continue to invest in the world markets with very low management expenses.

Some bad news: Now, from 1950-2000, fundamental returns were 10%: 4% dividend yield and a 6% earnings growth rate. These days, the S&P 500 has a dividend yield of only about 2%. Earnings growth rate estimates are subject to debate, but they hover around 6% still.

Predicting Speculative Return
However, the speculative return has greatly contributed to the high returns of the last 25 years for the S&P 500. This is due to a great increase of the overall P/E ratio of the stock market in recent history:

In 1950, the P/E ratio was only 7. During the dot-com bubble, it was over 40. Recently, the P/E ratio was as high as 24. It is very unlikely that this huge increase will happen again. So what does the future hold if P/E ratio either stay flat or fall? This will lead to a zero, and quite possible negative, future speculative return!

In my opinion, the fundamental return is still a solid reason why stock prices will go up on the long-term, especially if you are not investing only in one country or economy. Some people call it a belief in capitalism, that economic growth will continue and GDP will continue to increase. I simply believe the the passion and motivation of all the people out there, from Sweden to China to Brazil.

However, there is good evidence that you might not be getting that 8-10% annualized return that many investment calculators seems to guarantee. You have to look at all the sources of expected future return, and the possibility of P/E ratio contraction.

But wait, why don’t people time the overall market based on P/E ratio? Some authors do recommend this. The problem is that the P/E ratio can also vary wildly for decades (see above), and most people don’t have either the patience or cash to fully see it through. For example, historically this has meant staying out of stock for 15 years at a time.

Will the P/E ratio ultimately settle at 15? 20? 30? 10? I have no clue. As the saying goes – the market can stay irrational longer than you can stay solvent. If it makes you feel better, as of this week, the P/E ratio is around 16. So the future speculative return from this point is starting to look more promising. 🙂

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  1. Amen bother! I’d caution you, however, not to say we’ll likely never see a P/E ratio over 24 again. Greed is a powerful thing. My money is betting for another future speculative bubble. Previous bubbles apparently haven’t taught us a thing. Look at the tulip craze. Irrational exuberance.

    Also, isn’t dividend yield inversely proportional to stock price? Don’t companies distribute dividends independent of share price? If so, wouldn’t the dividend rate increase with lowering stock prices? If stock prices decrease by 50% while earnings (and subsequent distributions) remain constant, I’d venture to say that the dividend rate would double. This is great news for investors.

  2. What is your source for the market’s current P/E ratio?

    The Wall Street Journal seems to indicate your market number falls between the trailing and forward P/E ratio of the S&P 500:


  3. This is pretty informative information and sort of technical. But what is going on right now is hardly based on any technical information. Fear and speculation are driving down the markets more than anything. How do you account for that?

  4. While I generally agree with this concept over relatively short periods (such as 40 years), there is a fundamental problem with assuming never-ending earnings growth, and it is that growth rates are exponentials, and as we know from math class, an exponential function will exceed any other function over the long term, which is not sustainable. For example, it would not be possible to have 3% real economic growth for hundreds of years, because we cannot expend our use of resources at an exponential rate since we have a distinctly finite amount of natural resources. When you look at that S&P chart, it is only a 100 year span, which is barely one human lifetime. As far as I know, there aren’t records of stock markets over hundreds of years that demonstrate positive rates of return over that time period. But if such a chart does exist, by all means please show it! I would love to be proved wrong. 😉 Without such evidence, I think we are taking it more as a matter of “faith” that capitalism and stocks will continue to grow during our investment horizon, which may be more of a gamble than we think.

  5. Your chart is out of date. The range for 1 year is now about -45%, and we may soon breach your 5-year -2.4% number…

    I know it’s hard to keep up during this generational meltdown, but try to not mislead your readers.

  6. And with the current yield on DIA approaching 3% stocks are beggining to look more attractive that fixed income..

  7. When people talk about stock returns, I feel like they seldom do a good job specifying whether they are talking about real returns or inflated returns. When you say (for example) 6% earnings growth, I assume that we’re talking about 6 actual percent – not 6% real (more like 9% or something after inflation). Assuming 3% inflation, the “real” earnings growth would be 3% here, right? If you follow the assumptions for the next 10 years on the graphic, that would estimate future returns at 4% real… Which is a bit depressing.

    Is that correct, Jonathan? I like to think about stock market returns in terms of real returns, because inflation has a good long time to do its worst before I’ll be retiring.

  8. If you are an insurance company, and you have assets of about 100 million, say — how much insurance should you legally be allowed to underwrite? I would think you should be able to cover that 100 million in the event of an emergency. What gives them the right to insure more accounts than they could possibly cover? I heard a panel of experts on CNBC discussing how these people “risked the system”. If that’s the root cause of the market downturn, then the first thing we should be doing is setting up very strict regulations against the insurance industry. I’m not following why we need to deluge the market with cash. Maybe it’s really time to let interest rates go where they are supposed to go. Then maybe some of us, who lost 20 or 25 percent in the last 2 weeks, could lock up our money in something (safe) that earns 10% a year, and in three years we will be back in business. Why are we giving them more leverage to do their insurance calculations that caused this problem in the first place?

  9. Are those “calendar year” returns? Because if not, we’re defining a whole new low. I usually use VTI conveniently as my measure of “the stock market” and in the past 1 year it is off 44% (not counting dividends which help some).

    If it is calendar year, then I have to say, that graph isn’t so helpful for a person asking about risk tolerance. We might very well see some recovery before December 31st, and for the calendar year we might not be off 44% at all. That doesn’t help a person trying to look to history to decide whether right now is uncharted territory or not.

  10. Your ultimate question though was what is the source of market returns? I’ll answer your question with a question that troubles me some: What is the source of continually increasing demand for energy, or the continually increasing size of the economy?

    Do these not (historically) grow exponentially perhaps because (historically) population grows exponentially? The more people there are, the more energy they use and the more money they spend, etc.

  11. Very interesting. Thanks for posting this. I do have a concern with this school of thought. What if you’re 60, planning to retire soon. Market is down 40% and it may take up to 7 years to get back to where it was … the thing is that you as a retiree probably don’t have 7 years.

    I work with someone in this situation, who’s getting ready to retire and planning to live off the returns of her investment. While she knows that generally the market goes up, the time is now for her.

    There’s something that’s fundamentally flawed in the way the market works … you’ve invested over the course of the last 5 years and have made some money, however, in the course of one week, that is evaporated. Forgive my cynical point of view; i just feel that it’s important to consider the above.

  12. Banditfist says

    You are not taking into account the fact that mark-to-market is not being done. FASB 157 has been negated. They keep changing the rules. So, how do you know that the balance sheets of any company is true. You don’t.
    Without trust as to the validity of a company’s true worth, you price in a premium that it is not worth what they say it is. This equates to a lower price. Cya!

  13. Where did you get your up-to-date calculation for p/e for the whole market of 16?

  14. While it may be true that the earnings of a broad index of companies should roughly track the economy in the long run, those earnings (at least in the last 25 years) have increasingly been given to the people running the companies.

    When you buy a share in a company, you are essentially buying X% entitlement to those companies earnings….BUT, unfortunatley we haven’t been getting what we paid for. When the board of directors continue to grant options to the company Execs, they are diluting our share of the company without our permission? Are we really still entitled to the same percentage of ownership we thought we originally purchased?

    I do not have any data to support my claims, but I’m willing to bet that over the long-term the average company has expanded the total number of shares it has outstanding.

    And my guess is that we will find a VERY disproportionate share of those shares outstanding have gone to company insiders, rather than the average individual investor.

    But over the last 25 years, the average individual investor has not cared so much about things like earnings and dividends because speculatve demand has kept pushing the share price over and above what the real earnings per share suggest is should. If the public finally wakes up to this scheme, maybe things will finally change.

  15. Trent, I found it here:


    Then click on the link that says “S&P 500 Earnings (Operating, As Reported & Core) and Estimate Report, includes Divisors and Aggregates, Core Breakdown, and Dividends”

  16. What do you want, inflation or deflation? I’d much rather have inflation — eventually taxes will be raised (hopefully on the people who grabbed the golden parachutes), etc.., but let the government keep bailing and all we are going to have is deflation forever, ie. Japan.

    Let the chips fall now and don’t try to prevent recession — it’s only going to prolong the agony. Whatever money has been pledged to help the economy should be put into capital projects, for the people who may be losing their jobs soon and will need new ones.

    But I’ll probably change my mind tomorrow! I just want this to end. And not take 5 years to recover — that’s just too long to sit still.

  17. Your chart is out of date, and also the numbers given are not inflation-adjusted. This makes a huge difference, because years with high inflation and poor real returns are being marked as good years.

    Additionally, the historical data is just very poor. Do you want to bet your retirement on fifty years of data? Japan’s stock market now is below where it was 25 years ago.

  18. Chad @ Sentient Money says

    One of the big reasons people don’t realize historical returns is selling at times like these. Studies have proven again and again that the returns over a multi-year period from lows like this are missed if you wait for everything to stabilize. This is because there are only a handful of days in a multi-year period that bring top returns.

  19. Hi Jonathan,
    Nice post. I wrote something similar as well.
    One question on the side: Can you share the CSS/script for the toolbar buttons to add to digg/stumble upon? I have them but could not figure how you get the number , for example: Delicios(2 saves: tagged investing),

  20. Brian,
    returns are positive over the millenia. Check Bernstein’s “Birth of Wealth”. He shows returns go back to the Roman Empire. If I recall correctly, the “real” returns average was 4% or so.


  21. I sort of agree with Brian and Sam. For one, our resources cannot support growth forever,and I think even 100 years is much. Consider the fact that our population might triple by 2100, and if everyone wants to be 4% (annualized) more wealthy, we are talking about an overall wealth growth of 100. A good amount of this wealth will depend on resources…better start buying real estate on the moon and farming the oceans if we hope to keep this up.

    On another note, I am a bit skeptical of the numbers we keep hearing about 8%+ returns on the stock market that we’ve been so conditioned to accept in the long term. Looking at the Dow Jones from 1913 to now, we see an increase of about 160x, while the dollar fell about 20x according to http://www.usinflationcalculator.com/
    This makes for a real growth of 8 over 95 years, or annualized return of 2.4%, not particularly appealing. Why is it that whenever we hear the returns the stock market, we hear 1. about the US only (survivor-ship bias) 2. the last 30-60 years (periods of high growth) and 3. returns not adjusted for inflation (those in-n-out burgers aren’t 15 cents anymore). I think in general we need to accept that passive income will only go so far and that USA may not be number 1 forever.

    Please correct me if I am wrong anywhere, I am interested in starting a discussion.

  22. Again – If you are just looking at charts of indexes like the S&P 500 and Dow, they do *not* include dividends. Look at the chart above – dividend yield has been a huge component of total return.

    As of this week, the dividend yield of the S&P 500 is around 3%.

  23. Oops, my bad. I found that avg dividend yield since 1950 was 4.8%. I guess that makes it around 7.2% real return, assuming dividend yields were the same in the early 1900s. I guess that’s pretty good for a real return. Your charts do not account for inflation, I presume?

  24. Karl, also the claimed 8%+ return generally does not include inflation (i.e. is not a “real return”). The “real return” of the stock market is definately lower than 8%. However, the real return of cash and bonds is even lower, so in the long run the market is still better than these.

    For me, I’ve estimated what I will need when I retire assuming an average of 5% annual inflation. This may be inaccurate, but it’s the best I can do.

  25. Brian: For example, it would not be possible to have 3% real economic growth for hundreds of years, because we cannot expend our use of resources at an exponential rate since we have a distinctly finite amount of natural resources.

    One logical flaws here: Real economic growth is not simply an extension of our use of natural resources. We also have to measure the efficiency of our use of these resources.

    If I can convert unused resources into usable resources, I can generate economic growth In fact, isn’t that pretty much all economic growth? Yes there are finite resources, but we’re a very long way from using them all.

    Availability of resources is definitely a limiting factor.

    R&J: What if you’re 60, planning to retire soon. Market is down 40% and it may take up to 7 years to get back to where it was … the thing is that you as a retiree probably don’t have 7 years.

    I work with someone in this situation, … the time is now for her.

    So if 60 is was her time, why does this market flux affect her at all? If she’s planning on retiring in the next 5 years how much of her portfolio could possibly be in high-risk stocks?

    …planning to live off the returns of her investment…

    Huh? Are you saying that she was planning to cash out her stocks on the date of her retirement and that she’s now lost of bunch of that value?

    There’s obviously some missing information here. Could you help me?

    Heck could anybody help me? Jonathan made a similar comment here: But if I was close to retirement and more than 60% stocks in my portfolio, I would definitely have fear.

    Why is anybody scared here? If you’re “close to retirement” yet still “in 60% stocks”, then it sounds like one of the typical scenarios is coming to bear.

    I guess, people will just have to keep working. But they knew that risk when you kept that much of your portfolio in stocks, right? They knew you weren’t going to retire in 2010 if the market had a bad year and ate 15% or 20% of your retirement fund, right?


  26. Great that you put it simply across! Volatility in stocks, I believe, is then generated mainly by speculative returns, which in the long run, becomes negligible. Which also explains why stocks ‘stabilize’ in price in the long run. The total return becomes closer to fundamental return.

  27. Jack Goldman says

    Dow stocks were 1,000 silver dollars in 1966 and are 1,000 silver dollars in 2016. Stocks don’t go up, gold does not go up, houses do not go up, cars do not go up, the US counterfeited paper bank debt note goes down, down, down. Since 1966 the dollar has lost 95% of it’s buying power. It’s a counterfeited illusion that stocks go “up”.

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