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How to Erase the Lost Decade

October 16, 2010
How to Erase the Lost Decade?

IT’S been a rough decade for the stock market — even when considering its recent rally. But frustrated investors can at least fall back on a comforting thought: that the market will eventually “revert to the mean,” or snap back to its historical average returns.

He says that instead of waiting for stock performance to return to the mean, investors would do better to pay attention to whether price-to-earnings ratios are reverting to long-term averages.

That could take a while. Mr. Arnott uses 10-year averaged earnings to calculate the market’s P/E, a conservative method that smoothes out extreme swings in corporate profits. The method is favored by Robert J. Shiller, the Yale economist.

Despite the market’s recent troubles, its P/E ratio, based on this method, currently stands at 21. That’s significantly higher than the long-term average of 16 for domestic stocks.

Until that changes, stocks are likely to be in store for below-average returns, Mr. Arnott argues. In fact, since 1900, whenever P/E ratios have ranged from 16 to 24, stocks have gained about 7 percent, annualized, on a nominal basis — or 4 percent after inflation — in the following 10-year stretch.

For his part, Mr. Arnott says he thinks that stocks are likely to produce total returns of about 6 percent a year. He comes to that figure by taking the current 2 percent dividend yield for the S.& P. 500 and adding it to the long-term earnings growth rate of around 4 percent.

Whatever figure turns out to be right, the bottom line is that “people should ratchet down their expectations for stocks,” he said.

“There’s no harm in hoping that things turn out better,” Mr. Arnott added. “But the danger is assuming and planning for the best while saving as if the market can do your work for you.”

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