December 7, 2010
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There is nothing more important to long-term investors than real returns. Real returns – returns net of inflation - are what eventually fund consumption. The inflationary component of returns only offsets price increases.
Investors can lock in a certain real return through Treasury Inflation Protected Securities (TIPS). The principal value of TIPS increases with inflation (or decreases with deflation) and interest is paid bi-annually on the adjusted principal. At maturity, investors are paid the adjusted principal or original principal, whichever is greater. Unfortunately, the current yield on a 10-year TIP bond is a paltry 0.74%, far below its average since 2003 of 1.9%.
Unlike TIPS, the future real cash flow from stocks is uncertain. However, a number of academic studies1 have found that long-term real returns are somewhat predictable as stock market prices exhibit a tendency to revert to levels determined by fundamentals such as corporate earnings. In this regard, the following exhibit sets out the real earnings yield – the inflation-adjusted, 10-year smoothed earnings divided by price – of large company U.S. stocks since 19262.
Since earnings are the engine that drives both dividends and capital gains, the real earnings yield is a useful valuation measure of stocks. As illustrated, the real earnings yield as of September, 2010 is 4.9%. In essence, investors in U.S. large company stocks today are prepared to pay $1.00 for every 4.9 cents of real earnings. This is substantially higher than the record low yield of 2.3% in December, 1999 when euphoric investors pushed stock prices to delusional extremes during the technology boom. However, it is well below the long-term, average real yield of 6.7%.
Low real earnings yields historically have been associated with lower, real (i.e. inflation adjusted) stock returns in subsequent years. Conversely, high real yields have been associated with higher realized real returns. This is illustrated in the following scatter diagram which compares the monthly real earnings yields of large company U.S. stocks from January 1926 to October 2000 with the annualized real return actually earned over the subsequent ten years.
1. See, for example, Campbell, John Y. and Robert J. Shiller. 2001. "Valuation Ratios and the Long-Run Stock Market Outlook: An Update." Cowles Foundation Discussion Paper No. 1295. Cowles Foundation for Research in Economics New Haven: Yale University. March.
2. The real cyclically adjusted earnings yield has been derived from Shiller’s cyclically adjusted price earnings ratio available at http://www.irrationalexuberance.com/index.htm.
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