What Long-Run Returns Can Investors Expect from the Stock Market?

When investors make financial plans, their strategies depend on the returns they expect from investments in the stock market. The expected returns from stocks affect how much investors save, how long they plan to work, and how they allocate their portfolios among alternative investments. Their strategies are most likely to be successful, of course, when they have realistic expectations about stock returns. Over the past several years, stock returns have exceeded their long-run historical averages. For example, the IS percent average annual return on stocks over the last decade is substantially higher than the 10 percent average return over the previous 100 years. Stock returns were particularly high in 1995 and 1996, averaging almost 30 percent for the S&P 500 stock index. Market observers have reacted to high stock returns in different ways. Many individual investors, for example, interpret recent market strength as the beginning of a new era, with 15 percent returns continuing into the foreseeable future. In contrast, market professionals are generally less optimistic. Indeed, some analysts interpret high stock prices as an indication that future returns will be below their historical average. This article analyzes how macroeconomic fundamentals and high price-earnings ratios on stocks will affect long-run returns. The first section reviews the stock market's recent performance and describes how investors and analysts have reacted to this performance. The second section shows how macroeconomic trends imply that long-run returns will remain close to their 10 percent historical average. The third section analyzes the long-run relationship between price-earnings ratios and returns. The section shows that high price-earnings ratios are consistent with lower long-run returns, and argues returns may have declined because the stock market is perceived as less risky. RECENT VERSUS HISTORICAL MARKET PERFORMANCE The strength of the stock market has led to diverse opinions about future stock returns. While many individual investors expect the high returns of the past decade to continue, many market professionals are concerned that returns will fall. This section compares the stock market's recent performance with its historical performance, and discusses how market observers have reacted to recent market strength. Stock investors have received higher returns in recent years than they have received over longer historical periods. Total returns on the S&P 500 index, which include the effects of price increases and dividends, have averaged more than 17 percent per year since the 1982 lows.^sup1^ As a result, this index was recently more than nine times higher than it was during the 1982 recession.^sup2^ The consistency of recent market strength can be illustrated by averaging returns over ten-year intervals to smooth out annual volatility. Average ten-year returns have been in the vicinity of 15 percent since 1984 (Chart 1).^sup3^ These mid-teen returns, of course, are substantially above the 10 percent average returns over longer historical periods (Siegel).4 Another measure of stock market performance is the length of time since returns on market indexes have declined significantly over the course of a year (Chart 1). Prior to 1974, stock prices usually declined significantly about every five years. Since 1974, stock returns have been positive in every year except 1987, when the year-over-year return was only slightly negative.^sup5^ With only one small year-over-year decline in 23 years, this post-1974 period is unprecedented in U.S. stock market history extending back to 1802 (Schwert). High stock market returns have been driven primarily by rising stock prices. This has led many analysts to conclude that stock prices are now too high. When analysts say stock prices are too high, of course, they are comparing prices to commonly used fundamental measures of stock value, such as book value, dividends, and earnings. …