Sharp one-day drops in the market can be unnerving, but they haven't changed the basic math of investing.
You know the advice: Ignore stock market swings. They don’t mean anything. Just buy and hold.
Of course, that’s easy counsel to live by when the swinging is mostly upwards. It’s even possible to follow such advice after a long market decline, once you’ve gotten used to the bad news. And near the bottom, when even the pessimists start to express some optimism, well, then it’s fairly easy to stay the course.
Times like now, however, are a true test of a long-term investor’s resolve. After a bull-market run so smooth that pundits were complaining about “complacency,” the Dow has delivered a string of triple-digit daily drops, confusingly interrupted by a 274-point rally last Wednesday. At such times, your head is saying no one can reliably predict the market’s next flush of fear or greed. But your gut worries that maybe something’s about to break.
The reality, though, is that if you look at the factors that really drive the long-run returns you care about, the market doesn’t look much different than it did a week ago. Which is to say: It’s priced to deliver kind of meh returns. But those returns still look better than your easiest alternative, bonds.
There’s a very simple Finance 101 way to think about what you’ll make on equities. In essence, a stock is just a claim on the flow of cash from a company. You can think of that as the company’s earnings, or—if you want to keep things tangible—as the dividend checks it pays to investors. (No, not all companies pay dividends, but in theory that’s the eventual purpose of all profits.) Right now, investors who own an S&P 500 index fund get paid a dividend yield of about 2% per year.
The nice thing about a dividend yield is that it’s not just a measure of how much income your investment is delivering to you. It can also tell you whether stocks are generally cheap or expensive. Imagine that a stock paying out $2 in dividends per share is trading at $100—that’s a 2% yield. Now say it falls in price by $35. Terrible news for current holders, but potential buyers can now get the same $2 payout for just $65 a share—a 3% yield. In that light, the stock looks like a better bargain.
So: Low dividend yields suggest pricey stocks, and higher dividend yields cheaper. Right now, even after the recent declines, dividend yields look okay but not fat, just as they have for a while:
Note that the almost 4% dividends came in 2009, when stocks were at the bottom of the post-crisis crash. Around 2000, at the peak of the tech bubble, yields were about 1%.
Wait, does all this mean I’m only getting a 2% return on stocks? No, it doesn’t, because you also buy stocks expecting their earnings or dividends to grow over time. Using a somewhat simplified, classic rule of thumb — I’m relying on Bill Bernstein‘s book The Investor’s Manifesto plus this useful paper (PDF) from the money managers Research Affiliates — the expected return on stocks right now is the 2% dividend yield plus the historic rate of growth in dividends or earnings-per-share of about 1.5%. So think 3.5%, maybe 4%.
That’s a real return above inflation, but still a disappointment compared to the 7% historic rate for equities since 1926. Then again, it’s much better than the fixed-income alternatives: The real yield on inflation-adjusted Treasury bonds, or TIPS, is 0.35%.
A 4% return is just a baseline. If investors collectively decide they want to value stocks higher in the future, and can live with lower yield payouts, you’ll get a bump on your investment today. If they lose their taste for the risk of stocks, you’ll do worse. But that’s driven by whatever goes on deep inside the wet, gray stuff under millions of investors’ skulls, not the profitability of the companies you buy today.
The past six market days have hardly nudged this math, except to move it slightly toward stocks being a better bargain. Before the start of last week, the S&P had a one-year total return of more than 18%. Now it’s one-year return has tumbled to 12%. That’s disappointing and, yes, anxiety provoking. But if you see 4% annual return as your basic expectation, reversals from years of high gains should come as no great surprise.