Here’s a great piece by Howard Marks from his 2000 memo where he asks the bulls one question:
What’s been the average performance of stocks bought at p/e ratios in the twenties? I don’t think the return has been in double digits. I’m not even sure it’s been positive!
Here’s an excerpt from that memo:
What Can Reasonably Be Expected from Equities?
In a little drama that I’m sure has played out at thousands of organizations in the last year, a charitable organization investment committee that I chair began to question its conservative portfolio and ask whether it should have more in equities. As a result, we commissioned some bond/stock allocation work from our consultants. Its conclusions were most curious.
Their model called for higher equity allocations, predicting that they would lead to higher overall returns on the portfolio and lower risk. Why? Because equities were projected to return 14% and risk was defined as the probability of failing to average 8% over a fiveyear period.
First, I said, I would never have any part in a process that equated higher equity allocations with lower risk. I suggested that risk be defined as overall portfolio volatility, and that took care of that.
But second, I questioned the 14% projected return from equities. Equities returned 28% in 1995-99, I said; did someone think halving that made for a conservative projection?
No, I was told, the support mostly came-from the 13% long-run return on equities:–(I always thought it was 10% or so, but it seems the last five years have changed all that.) I could only think of one way to respond: I offered to put up my money against that of the consultant’s researchers and “take the under.” I doubt strongly that equities will return 14% or anything like it in the next decade. Corporate earnings have traditionally grown at single-digit rates, and I don’t feel that’s about to change substantially. With p/e ratios unlikely to rise further and dividends immaterial, single-digit earnings growth should translate into single-digit average equity performance at best for the foreseeable future.
In the end, I feel there has been unreasonable reliance on the average historic return from equities, be it 10% for 1929-92 or 13% for 1940-99. What’s been lost track of is the fact that p/e ratios were much lower when these periods began and since then have risen substantially. I just don’t believe that further p/e expansion can be counted on. How do I view the issue? I ask the bulls one question: What’s been the average performance of stocks bought at p/e ratios in the twenties? I don’t think the return has been in double digits. I’m not even sure it’s been positive.
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