Now that this great 2013 is coming to an end, everyone is wondering what will follow in 2014. This is important for setting client expectations and for planning the year ahead. The media has already surveyed experts for their forecasts of next year’s market returns. There is a formula that can help us frame our own outlook, and it can also be used to infer the underlying assumptions in expert forecasts. It goes like this:
Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1
I first saw this formula in the late 1990s used by Rob Arnott and Peter Bernstein to show why there would be a price to pay for what we ultimately recognized as a growth bubble. It was subsequently published in an article, “What Risk Premium Is ‘Normal’?” in the March/April 2002 Financial Analysts Journal. This formula is simple yet elegant, saying that total return equals dividend yield plus some estimate of expected price change, in this case the compounding of earnings growth with investor-driven changes in the price/earnings ratio.
You can use the formula yourself, plugging in your estimates of earnings growth and ending P/E. For example, the following table uses the formula to peek into 2014. The cell highlighted in yellow – 6% earnings growth and an ending P/E of 15 – is the average long-term situation. In other words, if 2014 is “average” we’ll see a 16% loss next year. But what if it’s not average? The purple cells highlight a band around the average and indicate a performance range between a 13% gain and an 18% loss.
We can also use the formula to look beyond 2014, to the end of the decade, as shown in the following table:
What do you think 2014 and beyond will bring? Is the formula helpful to you?