Future Returns Correspond to The Current “Total Cost of Capital.”
It’s an intuitive and simple formula. Add (1) the earnings yield on the stock market; PLUS (2) the current interest rate on a ten-year US Treasury; PLUS (3) the average inflation rate over the previous year. I’ll call the result “the total cost of capital,” because it takes into account all of the following factors: stock prices, corporate earnings, inflation and the opportunity cost for risk-free bonds.
Since 1900, there has been a strong correlation between the “total cost of capital” and the stock market’s subsequent ten-year returns. Using data from Professor Robert Shiller’s homepage, I calculated the annual ten-year returns on the stock market (including both capital gains and average dividends) for each month from January 1900 to January 2012. I used nominal values, not inflation-adjusted (the reason why is because I use inflation in my next data series). The red line on the chart (below) shows the stock market’s average ten-year annual returns for the last hundred years.
Next, I compared the annual rate of return to the “total cost of capital” at the start of each month from January 1900 to January 2012. Specifically, (1) I calculated the earnings yield for the market by dividing the nominal earnings by the nominal price, (2) I added the prevailing interest rate on a ten-year Treasury and then (3) I added the average one-year rate of change for the Consumer Price Index. The blue line on the chart (below) shows the “total cost of capital.”
The chart visually demonstrates the close relationship between future long-term returns and the “total cost of capital” prevailing at the time when investors buy stocks. (For statistics enthusiasts, I calculated a strong correlation of .59 between the two data series).
So Where Does That Leave Us Today?
According to the fund’s sponsor’s home page, the earnings yield for the SPDR S&P 500 Index Fund (SPY) stood at 4.66% as of Friday, February 17th. Professor Robert Shiller’s data puts the most recent average annual inflation rate at 5.36%. According to Marketwatch.com, interest rates on a ten-year US Treasury are now at 1.93%, putting the “total cost of capital” today at nearly 12%.
And what does history show us about future stock market returns when the “total cost of capital” is between 11% and 13%? The answer is that from 1900 to 2012, the stock market has tended to deliver annual ten-year nominal returns of 7.96% on average whenever the “total cost of capital” is within a 1% range of where it stands today. Most of those times, the market’s ten-year annual returns tended to fall somewhere within a 4% and a 12% return.
There are two times in history when the earnings yield for the market (denoted with the pink line) stood at around 5% (close to today’s 4.66% earnings yield) and when the “total cost of capital” stood near 12%. Those were the years 1912 and 1952, and the market’s subsequent ten-year annual returns were in the ranges of 4% and 12%, respectively. Those do not provide enough data points to draw any conclusions, but arguably provide some historical context for today’s market conditions.
What history seems to show is that spiking interest rates and surging inflation do not necessarily imply low or negative nominal future returns on the stock market – provided that corporate earnings keep up (and also provided that investors do not overpay to buy stocks). Obviously when inflation rises, the true economic value of those future nominal returns will fall correspondingly – but that does not imply that stock prices will necessarily go down. I’d say that it would be very hasty to conclude that the future for stock market investors is bleak from an historical standpoint. But as the data on the chart show, higher future returns do correlate strongly to a higher “total cost of capital.” Since today’s “total cost of capital” is low compared to other points in history, it would be equally hasty to conclude that future returns are likely to be glorious for today’s stock market investors.
So what could drive the “total cost of capital” higher from here? A combination of any (or all) of the following: (1) falling stock prices; (2) rising corporate earnings; (3) rising inflation rates; and / or (4) rising interest rates. With history as any guide, those are four key factors for investors to watch for going forward.
The investment lesson that I personally take from the data is that I should maintain a diversified portfolio of individual stocks with the following characteristics:
(1) a high earnings yield;
(2) strong pricing power for the company’s products and services (to help the company benefit from – or at least keep pace with – rising inflation);
(3) an ability to expand the company’s future earnings by reinvesting corporate earnings (as opposed to relying on outside debt or equity financing);
(4) low debt (and accordingly, less exposure to rising interest rates) or an exceptional credit history (which give the company competitive borrowing advantages when interest rates are climbing). As an aside, this is one of the reasons why I obsess over credit ratings. I calculate that nearly 88% of my portfolio is concentrated into companies with either zero long-term borrowings or credit ratings of at least A- or above;
(5) stable and growing dividends, so I can reinvest savings, take advantage of the power of compounding and also profit from dropping stock prices; and / or
(6) an ability to profit directly from higher interest rates.
Since I can not necessarily infer that the factors driving individual share prices are identical to those driving the overall market as a whole, my investment strategy should be to keep a broadly diversified portfolio with limited turnover (ideally, less than the turnover for the S&P 500). In full disclosure, I may fall short of my low turnover goal this year – I’ve pruned a number of positions this month to reallocate capital into more shares of Meta Platforms (FB) and T. Rowe Price (TROW) (both of which I personally view as bargains).
To highlight my potential biases, here are my current holdings and possible investment plans going forward: