How to Predict Stock and Bond Returns

Chapter 13 of A Random Walk Down Wall Street is where Malkiel teaches you to be a financial bookie. Not the kind who takes bets on horse races. The kind who can look at the market and make a reasonable guess about what stocks and bonds will return over the long run. You still won’t be able to predict what the market does next month. But you’ll have a framework for setting realistic expectations.

The Simple Formula for Stock Returns

Long-term stock returns come down to two things: the dividend yield when you buy, and how fast earnings grow after that. That’s it. Add them together, and you get a solid estimate of your long-run return.

From 1926 to 2010, stocks returned about 9.8% per year on average. The dividend yield at the start of 1926 was about 5%. Earnings and dividends grew at about 5%. Add those together and you get pretty close to 9.8%. The formula works.

Over shorter periods, though, a third factor shows up. It’s the change in how much investors are willing to pay for a dollar of earnings. The price-earnings multiple. When people are optimistic, they pay 30 times earnings for stocks. When they’re scared, they pay 8 times. That swing can make or break your returns for a decade.

Bonds Are Simpler

With bonds, it’s even more straightforward. The yield you get when you buy a bond is roughly what you’ll earn if you hold it to maturity. A zero-coupon bond makes it exact. A regular bond is close enough.

The complication comes if you sell before maturity. When interest rates rise, bond prices fall. When rates drop, bond prices go up. If you hold to maturity, none of that matters. If you don’t, it matters a lot.

And then there’s inflation. Inflation is the bond investor’s worst enemy. If you bought a bond yielding 5% and inflation runs at 5%, your real return is zero. If inflation goes higher, you’re actually losing purchasing power while getting paid interest. That’s a bad deal.

Four Eras That Tell the Whole Story

Malkiel walks through four periods of market history to show how all this plays out in real life.

Era I: The Age of Comfort (1947 to 1968). After World War II, everyone expected another depression. It never came. Stocks started with fat 5% dividend yields and low P/E ratios because investors were nervous. But the economy grew, confidence returned, and P/E multiples expanded. Stockholders got rich. Bondholders got crushed because they started with artificially low yields (the government had capped rates during the war) and then watched rates rise.

Era II: The Age of Angst (1969 to 1981). Inflation showed up uninvited. Vietnam spending, oil shocks, food shortages. By the early 1980s, inflation was above 10%. Both stocks and bonds got hammered in real terms. Here’s the interesting part, though. Corporate earnings actually grew at 8% during this period, ahead of inflation. The problem wasn’t profits. The problem was that investors got so scared they slashed the P/E multiple by two-thirds. Stocks went from selling at 18 times earnings to 8 times earnings. That collapse in valuations wiped out the gains from real earnings growth.

Era III: The Age of Exuberance (1982 to 2000). Everything reversed. Stocks started with high dividend yields and rock-bottom valuations. Then inflation calmed down, the economy boomed, and confidence came flooding back. P/E multiples tripled from 8 to 30. Bond yields started at 13% and fell over the next two decades. Both stocks and bonds delivered spectacular returns. It was the best time in history to own financial assets.

Era IV: The Age of Disenchantment (2000 to 2009). The Internet bubble popped. Then the housing bubble popped. Stocks lost about 6.5% per year for the whole decade. The math was brutal. Starting dividend yield was only 1.2%. Earnings grew at a healthy 5.8%. That should have meant a 7% return. But P/E multiples collapsed again, wiping out 13.5 percentage points. “The lost decade” was entirely a story of shrinking valuations.

What This Means for Your Future Returns

Malkiel’s framework gives you a way to estimate what’s coming. As of his writing, the S&P 500 had a dividend yield of about 2.5%. Earnings growth could reasonably be expected at 5 to 5.5%. Add those together: 7.5 to 8% per year. Not bad. But well below the 18% from the Age of Exuberance, and below the long-term average of 9.8%.

For bonds, the math was even simpler. Corporate bonds yielded 5 to 6%. Treasury bonds around 4%. TIPS offered about 2% after inflation. Decent, but modest.

The wild card is always the P/E multiple. If multiples expand, you do better than the estimate. If they shrink, you do worse. And nobody, Malkiel says, can predict which way that goes. Not economists. Not analysts. Not even God Almighty, in Malkiel’s words.

Don’t Drive by Looking in the Rearview Mirror

The biggest mistake investors make is projecting past returns into the future. People who lived through the 1982 to 2000 boom expected 15% annual returns forever. People who suffered through the 2000s thought stocks were permanently broken. Both were wrong.

The starting conditions are what matter. High dividend yields and low P/E ratios usually mean good returns ahead. Low yields and high multiples usually mean disappointing ones. You can’t control what happens next, but you can set your expectations based on where things stand today.

Malkiel closes the chapter with a story from an old radio show. A greedy investor wishes he could see tomorrow’s newspaper with all the stock prices. His wish is granted. He spends all night planning trades. Then he flips to the back of the paper and reads his own obituary. His servant finds him dead the next morning.

The lesson? Maybe it’s better not to know the future. What you can know is the rough range of what to expect. And for long-term planning, that’s enough.

Previous: Getting Your Financial House in Order Next: Investing at Every Age: A Life-Cycle Guide Part of the series: A Random Walk Down Wall Street Book by Burton G. Malkiel | ISBN: 978-0-393-08169-5