Investing

Vanguard founder John Bogle's 'Total Return Forecast' shows 7% returns from the market for the next decade. Under that scenario, investors will want to avoid the 10-year Treasury. Also, aim for a 7%-plus return on individual stocks, and emphasize low-cost mutual funds.

Market Commentary
Revise Your Market Expectations
By Hewitt Heiserman
RealMoney.com Contributor
10/26/2006 9:57 AM EDT
URL: http://www.thestreet.com/p/rmoney/marketcommentary/10317608.html

Given last week's hoopla over Dow 12,000, it's understandable that investors are feeling more than a little giddy about the market's long-term possibilities.

I agree it's time to revise expectations about performance, but not with a "sky's the limit" approach. There are going to be some pretty definite limits on returns, and that's going to require investors to rethink their portfolio strategy.

As my yardstick, I'm using some S&P 500 forecasts from John Bogle, founder and former CEO of mutual fund house Vanguard Group.

Full disclosure: Bogle wrote the foreword to my book, It's Earnings That Count. Fuller disclosure: I've seen Vanguard funds give desired results.

A few years ago, when I was treasurer of a foundation, I persuaded my colleagues to move our endowment out of a high-cost, poor-performing mutual fund and into a few Vanguard index funds. Costs play a big role in determining investment returns, and Vanguard is known for being zealous about paring fees to the bone.

When I revisited the foundation's allocations not long ago, I warned the board that while the equity portion of the account had generated double-digit returns over the last few years, future returns should average about 7% a year (nominally, not adjusted for inflation), if history is any guide.

That's a pretty big guide-down, to put it in earnings season-speak.

The Bogle Total Return Forecast

I base my lowered expectations on Bogle's work on equity returns over long periods, which he says -- again, this is for the long term -- are equal to the sum of three factors:

1. the initial dividend yield
2. the ensuing growth rate in earnings
3. any changes in the price-to-earnings ratio.

Of these three factors, we can have the most confidence in the dividend yield because it's a known quantity.

The expected growth rate in earnings is relatively predictable within fairly narrow parameters, Bogle says.

However, the P/E ratio figured for 10 years from now is "highly speculative."

This approach -- which I've dubbed the Bogle Total Return Forecast -- has done well in terms of divining long-term trends, as the chart below shows.

The black line is the forecast total return for rolling 10-year periods ended 1957-2005, and the red line is actual results.

Notice that forecast returns trended down from 1957 to the mid-1970s, which matched actual results -- although Bogle's model was a few years early.

Beginning in 1983, the Bogle Total Return Forecast indicated we could expect several years' worth of double-digit returns, which is what we got.

As for the fin de siecle Internet bubble, the model was right (but again, early) in forecasting lower returns than many investors had grown accustomed to in prior years.

What does the Bogle Total Return Forecast indicate we can expect for the next 10 years?

Start by using an initial S&P 500 dividend yield of about 2%. Figure in an expected 6% earnings growth rate, a "little higher than the past," Bogle points out. He prefers using long-term numbers when making long-term forecasts, plus, corporate America is currently enjoying above-average margins -- which, if history is any guide, will regress downward.

Finish with a slightly lower P/E than what we have now, Bogle says (and I agree), because we have to take earnings with a grain of salt. There are just too many assumptions to get precise about this. He uses reported earnings from the trailing 12 months.

Using those figures, the Bogle Total Return Forecast projects nominal (or preinflation) returns of 7% a year through 2016. But this forecast return won't be smooth and is hardly guaranteed, Bogle reminds us.

Acting on the Forecast

Bogle Total Return Forecast Expected annual return from the S&P 500 for the next decade
Dividend yield (actual)	2.0%
+ Earnings growth (forecast)	6.0%
+ P/E multiple expansion	(1.0)%
= Expected annual return	7.0%
Source: Bogle Financial Markets Research Center, Kevin P. Laughlin

Now that I've shattered your dreams of retiring next year, I'll give you the implications I see for the average individual's portfolio.

Here's how I'd position myself in each of the major asset classes. For simplicity, I am excluding the effect of taxes from this discussion.

Bonds: With 10-year and 30-year Treasuries currently yielding 4.8% and 4.9%, respectively, a forecast 7% annual return from the S&P 500 appears to offer the patient investor more value than long-term government bonds.

Individual stocks: Look for situations that offer expected returns higher than 7% so that you're compensated for effort and risk.

Because of the risks inherent in individual stocks, attempt to achieve a margin of safety in case of what Benjamin Graham called "miscalculation or bad luck." Select companies that have high-quality earnings and a durable competitive advantage (including shareholder-oriented management) and that also sell at a discount to your estimate of the company's fair value.

Mutual funds: Emphasize the low-cost variety. With the typical equity fund, Bogle told cadets at West Point this past April, management expenses, sales charges, commissions and slippage between bid-ask prices can cost as much as 3% a year. So if your portfolio manager is able to match the market return every year (most don't over time), then your after-cost return is 4% a year.

And this 4% return, Bogle hastens to point out, is before inflation. After inflation -- which has averaged 3.3% a year for the past 25 years -- your expected real return (again, pretax) is maybe 1% a year.

I'd trust Bogle on this one; he just celebrated the 30th anniversary of the first low-cost stock market index fund for individual investors. Launched on Aug. 31, 1976, with just $12 million, "Bogle's Folly," critics charged, was a recipe for mediocrity. But today, Vanguard's flagship S&P 500 Index Fund has $110 billion of assets, as investors have seen that over long periods a low-cost fee structure wins.

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At the time of publication, Heiserman had no positions in the fund mentioned, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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