Investors are Reassessing Srocks’ Long-Run Potential

Ten years ago, after the stellar stock market gains of the 1980s, many of the smartest minds on Wall Street declared that the party was over.

In the 1990s, they said, stock prices would surely rise at a slower pace.

Instead, the blue-chip Standard & Poor’s 500 index produced bigger gains in the 1990s--an average annualized total return of 18.2%--than the 17.6% average return of the ‘80s.

That should serve to remind investors that the market has limited respect for its own history. The past may be of only minor help in predicting the future.

Today, the popular refrain once again is that stock returns will have to be lower in the next 10 to 20 years to balance out the high returns of the recent past.

It’s a reasonable assumption, and for most individual investors it would be more prudent to plan for lower returns than for a continuation of big numbers. If you set your sights lower, and the market then pleasantly surprises you, the extra return will be gravy.

But whatever the market’s performance turns out to be in this decade and the next, there will be reasons for it--a point that often is glossed over as analysts simply make declarations about how bad things are and how much worse they might get.

Stock price movements over time are driven in part by the fundamentals of the economy and of individual companies, and in part by investor psychology (which itself is influenced by the economic backdrop).

In other words, the market is unlikely to produce specific returns “just because.” Ten years from now, as investors are reviewing the performance of their stock portfolios in the current decade, they’ll almost certainly be able to point to certain events or trends that drove that performance.

Could the market once again surprise nearly everyone and generate average annual returns in the high single digits?

For starters, even if you believe in “regression to the mean”--that high stock returns inevitably give way to lower returns, so that the combined result is something closer to the historical average return--we’ve been living through that regression for the last 18 months as stock prices have dived. That’s what the worst bear market in a generation has been all about.

If you’ve been in the stock market for the last three years, your return may well be close to zero for that period: The Vanguard S&P; 500 index mutual fund has gained a net 2.3% a year over the last three years, according to Morningstar Inc. You would have been better off in a money market fund.

Measured over the last five years, the average S&P; index fund’s return works out to an annualized 10.4%. That means it is slightly below the 10.6% annualized average return on blue-chip stocks since 1926, as calculated by Ibbotson Associates.

By those numbers, then, the market’s bulls could argue that returns should be higher in the next few years, rather than lower, just to restore the historical average.

But let’s stick with the fundamentals. Here’s a look at three principal determinants of stock performance and how they might drive future returns:

* Corporate earnings growth. One of the basic tenets of investing is that a stock’s price should reflect the earnings that the company is generating for its investors. Over the last 50 years, earnings of blue-chip companies have grown at an annualized average rate of about 7%--which, in turn, has provided the underpinning for the market’s historical return.

If you expect that corporate earnings growth over the next decade will just meet the average of the last 50 years, there is the underpinning for at least some future stock price appreciation.

“I believe that very long-run capital appreciation [of stocks] mirrors earnings,” said Steven Wieting, an economist at brokerage Salomon Smith Barney in New York. However, because corporate earnings “can’t be assumed to vastly outgrow the economy in the long run, I tend to think that long-run total returns will be in the range of 8% to 10%, probably at the lower end of that range,” he said.

But in the shorter term, the relationship between earnings growth and stock appreciation isn’t linear. Earnings growth far outdistanced blue-chip stock gains from 1992 through 1994. The opposite was true from 1995 through 1999: Stocks performed far better than earnings.

The latter episode is the problem now, market bears say: Stocks rose too fast, relative to earnings, from 1995 until early 2000, they say. Even after 18 months of mostly falling share prices, the average blue-chip stock’s price-to-earnings ratio is above 20, compared with a historical average of about 14.

Those high P/Es will hold back returns for years to come, the bear camp argues.

“I’m a bull compared with most economists, but ... tell me that markets don’t already assume favorable economic trends going forward,” Wieting said.

Historically, it has been true that periods of high P/E ratios have given way to extended periods of below-average stock returns.

But earnings alone don’t determine stock prices. Which brings us to:

* Interest rates and inflation. The sharp decline in inflation throughout the 1980s and 1990s was a major factor in boosting stocks’ appeal in those decades.

Lower inflation allowed for lower interest rates, which meant that bonds and money market accounts paid less and thus provided less competition for stocks.

A low-inflation environment also makes investors more confident about the future and the economy. That, in turn, makes them more willing to pay above-average prices for promising stocks.

What about the next 10 years? If you believe that inflation and interest rates will stay low, there should be greater potential for stock valuations to remain relatively high and for investors to favor stocks over other options.

But if your outlook is that inflation and rates are likely to rise, that would be a major strike against the stock market. Rising inflation was a major agent in ruining the market’s returns in the late 1970s.

There’s another risk: If the U.S. were to fall into a deflationary spiral--such as what now grips Japan--it could be just as devastating for stock prices as an inflationary spiral.

What will determine the inflation trend? That brings us to:

* Political and other big-picture factors. Stocks performed so well in the 1990s in part because the big picture was so incredibly favorable for the United States. Communism all but died. The crime rate plunged. Energy prices collapsed and world trade expanded significantly, both of which drove down inflation. And until recently, peace seemed to be breaking out all over.

All of this made investors more confident, and the stock market rode that confidence tide.

Today, many investors no doubt view the world as a much different, and scarier, place. The future looks less certain. If that uncertainty deepens in the next few years, it undoubtedly will weigh on stock returns.

Every investor has to judge for himself how large the risks now are and what portion of his portfolio he can stand to bet on the future--meaning, by investing in stocks.

But in making that decision, remember that though it’s convenient to talk about market averages, your own portfolio may be anything but.

No matter what the economic backdrop, some companies are going to thrive, and so will their stocks. If you pick well, average market returns may be relevant to you only in the sense that you’ve beaten them.

Remember too that even a below-average stock market performance in this decade may still be a good deal compared with the alternatives.

“I think the prudent message is that equity investors should not count on average returns above 10%” from this point, said Ed Keon, a market strategist at Prudential Securities in New York. Even so, he said, “5% to 10% returns [would not] be bad in a low-inflation world.”

Even a 7% average annualized return over the next 10 years, Salomon’s Wieting notes, would beat the 4.52% yield you would earn by locking in a 10-year Treasury note today.

If it all goes bad, the T-note will have been the better choice, of course. Stocks are risky, but it’s necessary to take risks for the potential reward of higher returns. It was too easy to make money in stocks in the late ‘90s.

Now, it may just be that the risk-versus-return equation is finally back to normal.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to www.latimes.com/petruno.