With the Dow now in all-time high territory (the S&P 500 is within 1% of breaking the 2007 high), money's coming back into stock mutual funds – nervous money. It would be different if you could get a safe 5%, or even 3% return, but today's truly safe (no downside) investments are yielding negative after inflation.

As we discussed last month, many of today's strategies to avoid market risk offer little risk reduction (and might actually escalate risk) with no longer-term upside boost. Commodities fit this bill.

Although it's true that today’s "record" market has better valuations than the last two record eras in 2000 and 2007, low-priced stocks don’t magically reduce shorter term downside. If they did, the 2008 slide would have been far less widespread and destructive than the 2000 slide off much more expensive stocks – an S&P 500 P/E ratio of 30-ish during the 2000 peak, compared to 18-ish in 2007. Today’s P/E is around 15. The hardest-hit stocks in 2008, notably banks, were some of the lowest P/E stocks in the market. 

Although valuations don’t protect investors from sudden downside risk, they will increase your longer-term returns, which is why we try to increase our stock allocation following slides and decrease it after major runs up – essentially the opposite of what fund investors do as a group. Low investor interest in investing increases returns and lowers downside.

Ballparking Future Returns

Many factors could trigger another major slide in the next few years, which is why stocks are intrinsically riskier than most bonds and cash. Yet it's possible to estimate an expected total return over, say, the next 10 years. When you look at the entire stock market, there are really only a few variables: the future GDP growth rate (which is unknown,) the starting P/E ratio (known) and the ending P/E ratio (unknown).

In a nutshell, the reason stock market returns have been in the low single digits over the last 12 years (up from negative during the worst of the last slide) is because the market's overall valuation (what people pay for each dollar of earnings) slid about 50%, while earnings themselves only roughly doubled. This is basically a wash, except for the trickle of dividends, which are usually eaten up by expensive funds and Wall Street fees. The S&P 500 started this 12-year journey with just a 1.1% dividend yield. It's now about double that.

To guesstimate the next 10-year returns, we start with the nominal GDP growth rate. Nominal means "with inflation." As a stock (and real estate) investor, a little inflation is your friend. Coca-Cola sales and profits inflate with everything else.

Unfortunately, this nominal growth figure is likely to be low over the next 10 years, partially due to  low inflation, and partially due to lackluster real economic growth as we raise taxes and cut spending without a new bubble (yet) in the economy to get everybody spending and investing more than they should (like they did in the 1990s and 2000s.)

We’ve been running about 4% nominal annual economic growth over recent 10-year periods (2 % inflation and 2% true growth.) This is likely a good estimate for the next 10 years, factoring in a couple of recessions and a few mild booms. Pessimists and the gold and Dow 5,000 crowd would say that's too high, but it would be at our lowest 10-year nominal growth rate outside of depressions. It’s a pretty low bar, considering our average is over 7%.

S&P 500 earnings tend to grow slightly better than the nominal economy (although they fall faster during recessions). Why? Several reasons. One is that profit margins have improved to record levels, growing earnings faster than top-line revenue growth, although this orange is nearly fully squeezed now, given low labor and interest costs that boost companies' bottom lines.

Another reason is that Starbucks is run better than your local coffee shop. And when we say better, we mean in terms of higher margin and faster growth, not necessarily better-tasting coffee (unless you prefer slightly over-roasted coffee that has more caffeine per ounce than anyone else's). The stock market doesn’t care who makes the best coffee. It rewards those that grow earnings quickly and reliably. 

Someday, as publicly-traded companies essentially become our entire GDP, this boost over GDP may slow, but that day is still far off, and maybe our GDP will grow faster once all the Mom-and-Pop restaurants are rubbed out by The Cheesecake Factory. Sad, but true. The stock market doesn’t care about nostalgia, either.

We’ve seen about two percentage points better in recent years, and we’ll stick to it. Note: if publically traded companies start growing slower than the economy at large, returns will suffer.

In this fantasy future, we’ll see earnings grow at 6% (4% from the economy 2% from doing better than the economy.)

Dividends tend to grow a little slower than earnings, partially because dividend payout ratios have declined, but also because much of the faster-earning growth companies like Google don’t pay dividends. We’re going to use a dividend growth rate of 60% of the overall earnings growth rate, or growing about 3.6% per year (from the current base of an approximately 2% yield). This is far superior to bonds that don't grow coupon payments. But then dividends can get cut in deep recessions (as can higher-credit-risk bond coupons).

We'll use the same P/E ratio in 10 years as today, around 15. This is an important area in your returns and why buying into a market at a high P/E ratio can lead to terrible returns if when you're done – be it in two years or 10,  P/E ratios are significantly lower (meaning investors are paying less for a dollar of earnings). The P/E contraction of the last decade-plus is the cause of  lousy stock returns over the last 12 years, NOT poor earnings growth. 

With the above scenarios in place, we would expect the S&P 500 index to climb just shy of 70%, which, with dividends and growth of dividends equals a maybe 7.5% annualized total return. Not too shabby. This is before inflation, taxes, and investing fees. 

Of course, a few minor changes in the variables could lead to significantly higher or lower returns. If investors decide paying 1999 P/E ratios is a good idea in 10 years, you could expect a 14% annualized return. If we get some scary markets, or if retiring baby boomers start favoring bonds permanently and we have a P/E ratio of 8 in 2022, you might earn just 2.7%.

And those wild swings don’t factor in earnings growth rates. If the economy can’t get out of a 2% nominal growth rate, and investors begin paying just 10 P/E ratios because growth is so anemic, you'll have a 1% average annual stock return.

But even this bad case is not that bad, and it's fairly unlikely we'll see ten years without any real inflation-adjusted economic growth and sharply falling valuations. That's why it will be hard to lose more than 25% over the next 10 years in the stock market. That would require either a depression or negative GDP growth, usually the result of deflation, much like Japan has experienced.

And said deflation is probably the only way you're going to lose to bonds in stocks over the next decade, and that’s only if you're in high-credit-grade bonds. Junk bonds will default in big numbers with deflation, because it's very difficult for a company to make payments on high-rate debt if their revenues are sliding each year.

We don’t want to understate the risks of investor changes of heart and prices paid, even during a good economy. The Chinese stock market is down roughly 50% from 2007 (it was down 70% at one point,) while their economy grew nearly twice as much in 2012 alone as the U.S. economy has in total since 2007. The Chinese economy has doubled since 2007, yet their stock market has almost halved. Valuations were just too high, considering the risks in a fast-growing, yet questionable economy.

If China turns into Japan and 2007 was their 1989 Nikkei 39,000 moment, then the next 20 years are going to be crummy for investors in China. The Japanese economy kept growing until about 1995, well after the stock market peaked and went into a 20+-year tailspin.

So there you have it. An expected annualized return of about 7% for the U.S. stock market for the next ten years. A rocky 7% that could be more like 4 - 5% if investors are less "into" stocks in 10 years. Zero to 4% if we get some deflation along the way. Low double digits if we get some bubbles brewing.

It’s a 7% with likely 25%+-pullbacks along the way. It’s a 7% with minimal chance of becoming a 15% annualized in the 1990s style of fast-increasing earnings AND valuations. But it sure beats cash, bonds, and real estate. Stocks are in better shape than in 2000 or 2007, and the alternatives are so-so at best. 

That doesn't mean that the stock market can’t slide along the way, just that your next 10 years are more secure than your last. If investors start paying an 8 P/E ratio for stocks next year, we’d have a 45% slide in stocks. Use the pullbacks to up your allocations and consider out-of-favor stock fund categories along the way, and you could likely get closer to 10% or at least stick around 7%, with a little less downside than the market along the way.