The sharp spike in valuations during the 1990s has some economists saying that future stock market returns might be permanently ratcheted down. Indeed, a recent study by Ibbotson Associates estimates that the

S&P 500

will return an average of 9.37% annually over the next 25 years.

That's below the 10.7% compounded annual return the market averaged between 1926 and 2000. Just 1.3% less might not sound like a heck of a lot, but for folks saving for retirement or for their children's college education, such a drop could have tremendous implications. For example, say you invested $10,000 at age 35. If you didn't invest any more and earned the historical average compounded annual return of 10.7%, you'd retire with $258,657 at age 67.

But the lower market return estimate from Ibbotson would chop off a whopping $82,969 over that 32-year period. With a 9.37% return, you'd retire with only $175,688.

Bottom line: A difference of only a percentage point or so can produce a huge disparity in return over several decades.

Diminishing Expectations

Why the gloomier outlook? The research firm's paper points out that past market returns have been boosted by investors willing to pay more for S&P stocks. But the rapid growth rate of price-to-earnings ratios over the past several years isn't sustainable. Indeed, the P/E ratio of the S&P 500 stood at a measly 10.22 at the beginning of 1926. But by the end of 2000, it had surged to a hefty 25.96.

"The price relative to earnings won't rise another two and a half times in the future," says Peng Chen, vice president of research at Ibbotson and a co-author of the report with Roger Ibbotson. As a result, he doesn't expect returns to grow at the same rate as in the past.

P/E Ratio
1926 - 2000

Source: Ibbotson Associates

The Ibbotson report also considered other important factors in future stock market returns, including dividend payments, earnings growth and inflation. But changes in any of these factors are likely to cancel each other out, producing little net difference. For example, Chen and Ibbotson believe growth in dividend payments is likely to slow, but expect the decrease will be offset by higher rates of earnings growth as companies opt to retain earnings instead of paying dividends.

Meanwhile, the researchers of the report don't expect any large changes in the pace of inflation, which has averaged about 3% a year over the past seven decades.

The Debate Over Stock Returns Rages On

But other economists believe the Ibbotson conclusions are too optimistic. Robert Shiller, an economics professor at Yale University, contends that stocks

remain highly overvalued, and still have plenty of room to fall. He thinks bonds could outperform stocks for "maybe the next five or 10 years."

Shiller adds that it doesn't make sense to project past market performance into the future, because most of the companies that contributed to that performance have disappeared and been replaced by new corporations.

Moreover, it's possible that the market's robust average returns in the period since the 1920s represent an aberration, albeit a lengthy one, Shiller says. "When we look at U.S.

market data, we're looking at the most successful country in the most successful century in history." And the factors behind that prosperity may not hold true in the future.

Then there are those at the other end of the spectrum: prognosticators such as financial writer James Glassman and economist Kevin Hassett, whose book

Dow 36,000

argues that stocks have been

under

valued for decades and are actually less risky than bonds in the long term. The massive market gains of the late 90s merely reflected that stocks were catching up to their rightful values, the authors said.

But in the wake of the market's 18-month rout, that view isn't so persuasive.

Who's the Guru?

The wrangling among economists only shows that nobody is quite sure what to expect. But one thing is clear: It's naive to blindly rely on the past as a guide to future stock performance. So to be on the safe side, you might want to scale back your expectations for stock returns when you figure out how much to save for the future.