developing a long-term outlook for the u.s. economy and stock market

CFA Institute

Developing a Long-Term Outlook for the U.S. Economy and Stock MarketAuthor(s): William S. Gray, IIISource: Financial Analysts Journal, Vol. 35, No. 4 (Jul. - Aug., 1979), pp. 29-39Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478254 .

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by William S. Gray, III

Developing a Long-Term Outlook for the U.S. Economy and Stock Market

* The behavior of the stock market over the next 10 years will depend, not merely on the economy's real rate of growth - which should develop at a rate somewhere between the average of 3.9 per cent for 1956-66 and the average 2.7 per cent for 1966-76 but also on corporations' ability to adjust to inflation. U.S. corporations have already made great strides in recognizing and adjusting to inflation, and that adjustment will continue for the next three to five years, as inflation subsides from its current rate of 10 per cent to a 10-year expected average of six to seven per cent.

If the real rate of growth does develop as expected, and if inflation eases, corporate profits could expand at an average rate of nine to 11 per cent over the next decade. Higher payout ratios, running somewhere between 43 and 47 per cent, will generate dividend increases at the rate of 10 to 11.5 per cent per annum.

Acknowledging that small changes in his assumptions can have enormous impact on the final outcome, the author estimates that the S&P 400 will be in the neighborhood of 340 in 1988 (roughly equivalent to 2400 on the Dow), making for a corresponding rate of return for the 10-year interval of 17 per cent. If this estimate comes to pass, the most basic tenet of investment theory - greater reward for greater risk taken - will again be fulfilled. >

A LTHOUGH the rate of inflation in the United States has varied over the past decade, it has been consistently more severe than anything we

had experienced since the early 1950s and the Korean War. During the past 12 years, since the real onset of inflation in 1966-67, the U.S. economy has undergone a gradual yet significant adjustment to severe and persistent inflation. Our securities markets were the first to adjust, with prices falling as interest rates moved

upward to compensate for the loss of purchasing power that accompanies inflation. A bit later on, the general economy began to respond as business management came to recognize that our inflation was not simply a transitory phenomenon. More recently, the body poli- tic, responding to the need to create jobs and improve living standards in this inflationary environment, has begun to support measures designed to encourage capital investment.

This article examines the inflation adjustment process in the U.S., the behavior of the stock market and the "risk premium" implicit in the level of stock prices and offers, based on this examination, a 10-year forecast of stock prices and expected rates of total return.

Getting to the Present

While it was not fully appreciated at the time, the period from 1952 to 1966 in the U.S. was about as stable as one could expect in this complicated world. Although we experienced three recessions during this period, they were all relatively moderate. Real growth averaged somewhere around four per cent per annum, and the rate of inflation was a bit less than two per cent a year. Corporate profits were fairly healthy throughout, providing an average annual return on book equity of about 12 per cent.

Beginning in 1966, however, the Viet Nam War entered its escalation phase. The U.S. government debt escalated, too, and some of the increase was financed through the banking system. Consumers continued to spend as much as or more than ever; the result, of course, was too much spending relative to the quantity of goods and services being produced. The U.S. had embarked upon its "inflation problem" era.

William Gray is Senior Vice President of Harris Trust and Savings Bank, Chicago, and an Associate Editor of this journal.

FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1979 O 29



The Inflation Adjustment Process

The country's bond market responded promptly to the new inflation. As the inflation rate moved from roughly two per cent to six per cent between 1967 and 1970, corporate bond yields moved from around five per cent to nine per cent (in textbook fashion). Corpo- rate profits were slower to respond. Business management, unaccustomed to severe inflation, had not planned for the magnitude of operating cost increases that were developing; it fell back on borrowing larger amounts to take care of larger capital requirements.

By 1970, a great deal of stress had developed within the system, but it did not become fully apparent until we encountered a renewed surge of inflation between 1972 and 1974-75, when the rate went from below five per cent to around 10 per cent. Funds then became very short relative to demand, partly because business was unable to generate sufficient amounts from internal sources and partly because the central bank was clamp- ing down in an effort to contain the spiraling inflation.

Chart I shows the year to year increases in sales and capitalization over the period 1952 to 1977. Chart II illustrates the large increase in long-term debt that took place between 1965 and 1971, and Chart III points out the sharp change in corporate dividend payout policies between 1970 and 1973. While the increases in retained earnings and borrowing helped to cope with the financial pressures, Chart I shows that they were clearly inadequate during the 1972-75 period; they could not provide a fundamental solution to the problem. The solution required either a reduction in inflation or an increase in levels of profitability.

It is significant that returns on book equity (shown in Chart III) have tended to move upward since the early 1970s. Although this trend was interrupted by the 1974-75 recession-the worst in the postwar period- return on book in 1975 was the highest for any recession since World War II. But it is more than likely that the trend would have been even stronger in the absence of severe inflation. Chart IV illustrates the pattern of cyclical expansions over the past 10 years, using return on book equity and two key measures of resource utilization-labor and capital. These data suggest di- minishing utilization during the past decade-a pattern unlikely to have benefited returns on book equity.

Another thing to keep in mind is that the profits represented in the Standard & Poor's 400 series (which is the basis for our charts) are those reported by corporations. Most U.S. corporations do not charge inven- tories and depreciation on a current cost basis. There- fore, reported profits tend to be overstated (at times substantially) during periods when inflation is ac- celerating rapidly. On the other hand, the Commerce Department series on "replacement cost profits after tax" (after inventory and capital consumption adjustments) reflects an increase in profits of 112 per cent

between 1970 and 1977-almost identical to the increase in S&P 400 earnings over the same span. The nominal dollar Gross National Product (GNP) ad- vanced only 92 per cent during the same interval.

On the basis of either profit series, it seems that the U.S. economy is adjusting to inflation. Sometimes this type of adjustment is referred to as the inflation " flow- through" phenomenon: Price-cost relatives adjust so that the quantity of profits gradually moves in the direction of what is required to achieve reasonably sound financial positions and the means to accommo- date further increases in production and sales.

If the inflation rate continues at around seven per cent on a longer term basis, further flow-through will be necessary. But the flow-through process requires two basic conditions-an economy that is expanding at an average rate or better and the operation of free market forces. Mandatory price controls would hamper, if not actually negate, inflation flow-through. Further progress should be evident by the time we approach the next business cycle peak (let's say, 1982 or 1983). The S&P 400 return on book equity should be up around 17 per cent or better by that time, assuming profits continue to be reported on a historical cost basis.

A 17 per cent return on equity, combined with a dividend payout ratio of between 43 and 45 per cent (slightly higher than the current rate) should approxi- mate a reasonable equilibrium, if inflation remains at seven per cent and real growth at three per cent. Under such conditions, retained earnings could increase corporate equity at about 9.5 per cent per annum, and a small amount of outside equity financing (on top of the retained earnings) would suffice to provide necessary capital requirements. Of course, improving the rate of real growth (a goal that seems to be developing strong political support) would require further help-e.g., a lower inflation rate, an even greater increase in return on equity or some improvement in the tax treatment of investment returns (particularly capital gains).

In summary, if the increased profitability of recent years is any evidence, the U.S. economy is adjusting to persistent inflation and will continue to adjust- despite the possible interruption of one recession- during the next three to five years.

Stock Market Behavior

With the inflation that began to develop in 1966-67, the corollary increase in interest rates, increasing capitalization leverage and, later, the reduced dividend payouts, it seems remarkable (with hindsight) that common stock prices remained on a plateau between 17 and 18 times earnings well into 1972-yet another revelation of the staggering influence of investors' past experience (good or bad) in the face of basic changes in the fundamentals.

30 0 FINANCIAL ANALYSTS JOURNAL / JLILY-AUGUST 1979



CHART I % Sales and Capitalization* 20

18 A

16 Annual Sales Increase I

14 I

121

10 /X/?

lo

Capitalization and Long-~~apTalization

4~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~?

30

1920 r 5 '6 670_5 17

AnnualaIncreasC a pi Long-Term Debtalzto 30 1 _

capitaLon D Long-Term Debt as a

10

30

20 Percentage of Capitalization

10 1952 '55 '60 '65 '70 '75 1977

Source: FTC-SEC data on U.S. manufacturing corporations.




CHART Ill Returns on Book Equity and

1/6 Dividend Payout Ratios

14

12 Returns on Equity*

10

4 0;; 9 Retained Earnings as a Percentage of Equity*

2

0

65

60 55

50 Dividend Payout Ratios

45

40

35 1952 '55 '60 '65 '70 '75 1977

*S&P 400.

CHART IV % Returns on Equity and Capacity Utilization 16

15-

14

13- 12 Returns on Equity* 11 10

100

~ ~ ~ ~~ _ _ _Employment 95 _ _ _ - _ _ _ _

90

85 Capacity Utilization

80 r 75 _\

70 I I I 1968 '69 '70 '71 '72 '73 '74 '75 '76 1977 *S&P 400.

Source: U.S. Bureau of Labor Statistics and Federal Reserve Board.



Although price-earnings ratios remained relatively high and dividend yields remained relatively low (around three per cent) throughout 1972, the rates of return realized from common stock holdings were suf- fering badly, tending to decline both in absolute terms and relative to the returns from fixed income securities. At the same time, dividend payments were increasing very slowly. The S&P 400 dividends increased from $2.95 in 1966 to $3.22 in 1972-a total increase of only nine per cent in six years.

The ebb and flow of dividend increases on a longer range basis is revealing. Chart V shows the pattern of S&P 400 dividend increases (three-year moving average) over the period 1952-77. When we view this pattern in tandem with the dividend payout series, it becomes apparent that the implicit rate of increase in earnings dominated the rate of increase in dividends. More often than not, the dividend payout rate was moving in a direction opposite to that of the rate of dividend increase. The most notable exception was the 1970-72 period.

Since the pattern of dividend increases imparts a sense of relative growth, it is very likely to be one of the important factors influencing investor expectations about the future. Chart VI plots this same pattern of dividend increases (three-year moving average) in combination with a concurrent series of dividend yields covering the period from 1952 through 1977. This same chart portrays a third series representing the combination of the dividend growth rate and the dividend yield. Of course, the dividend growth rate changes have been the major variable in this combined series, since the annual dividend yield series has changed only very slowly over the years.

One version of the common stock present value model indicates that the discount rate equals the dividend yield plus the growth rate. We used this model as a proxy for the "expected return" from common stocks to see if it might bear some relation to realized rates of return from common stock holdings. We began with 16 different formulations of the dividend growth factor, each based on the S&P 400 dividends over a period of one to five years (starting as much as five years before and running as much as three years beyond any given year) so that each dividend growth rate represented the annual compound rate of increase for the particular cluster of years. We calculated the growth rate generated by each formulation for each year 1952 through 1977 and combined each such rate with the same year's dividend yield. In this way, we generated 16 different sets, each covering 25 years of common stock expected return figures.

Using a series of 160 correlation analyses, we compared each set of common stock expected return figures with the 1952-77 series of S&P Composite Bond yields and then compared the results with various combinations of corresponding (25-year) series of realized

returns from stocks and bonds, These latter series represented moving averages of three, four or five-year periods, using various leads and lags relative to the respective years of the particular expected return figures.

For example, the common stock expected return series in one of the correlation analyses reflected a dividend growth factor based on the 1948-52 dividends for 1952, the 1949-53 dividends for 1953, etc. These expected return figures were compared with the S&P Composite Bond yields of 3.00 per cent for 1952, 3.26 per cent for 1953, etc. We viewed the difference between the two figures for each year as a "spread," and compared the resulting pattern of spread figures with the differences between realized returns from stocks and realized returns from bonds, using three-year moving averages starting with 1950-53 for 1952, 1951-54 for 1953, etc.

The study proved to be revealing: Comparing the spread between stock and bond expected retums with the spread between stock and bond realized returns indicated a very strong relation between the unfolding pattern of dividend growth rates and realized common stock returns over the period from 1952 to 1977. While many combinations produced strong positive correla- tions, the best correlation resulted from using the dividend growth factor based on the five years ending with the given year and four-year periods of realized returns centering on the given year (e.g., 1951-54 for year-end 1952, etc.). The pattern of the relation between common stock expected returns and corporate bond yields, based on this best combination, is shown in Chart VII. It is evident that common stocks enjoyed a favorable spread throughout much of the 1950s, and that the spread did not in fact turn negative until 1969. While the spread remained negative until 1975, it became positive again in 1976.

An examination of the specific realized (actual) returns involved in the best combination is also revealing. Chart VIII shows the pattern of these retums: Although the four-year moving average of common stock returns has been moving downward throughout most of the past 25 years, a more favorable pattern may have begun in 1972. In any event, common stock returns dipped below corporate bond returns in 1969 (really the four years ended with 1971), remained negative throughout 1975 and turned positive again in 1976 (actually the four years 1975-78).

Chart IX reveals the relation between the expected return spreads and the actual return spreads; the high degree of correlation is apparent from the pattern of the dots. The coefficient of correlation was 0.919- striking indeed! The slope of the regression line- 1.7929-indicates that realized spread figures have tended to exceed expected spread figures throughout the past 25 years. Why? Probably because the risk premium implicit in common stock prices was di-




CHART V Dividend Payout Ratios and

% Dividend Increases 65

55

45

35

12

10

8

6

4

2

0

-2 1 1 1 I I I I I I I I I I 1952 '55 '60 '65 '70 '75 1977

-S&P 400. 1*Three-year annual compound rate.

CHART VI Dividend Yields and Dividend Increases

16

14 Dividend Yields and Increases

12

10~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~00 4 mioo~4 ?

S a~~~~~~~~~~~~~~~~~~~~a 2 .... *: ~~~~~~Dividend Yields-

jDividend *

0 _. ,-Increases* **

-2 1 1 I I I I I I i I I I I I I I 1952 '55 '60 '65 '70 '75 1977 *S&P 400.

**Three-.year annual compound rate.

34 Ol FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1979



CHART VIl % Expected Equity Returns and Corporate Bond Yields 18

16

14

12 Expected Common Corporate Bond Stock Returns* Yields* 10

8

6

4

2

15

10 Expected Return Point Spreads

5

0

-5 1952 '55 '60 '65 '70 '75 1977

*Dividend yield plus five-year annual compound rate of dividend increase. **S&P Composite Bond yields.

CHART VilI % Actual Common Stock and Corporate Bond Returns 25

20 t~~~~~~~Cmo Stock Returns

15

10

S Corporate Bond Returns*

-5

20 15L

1S0 Actul Retur Pot Sprads

-10 1952 '55 '60 '65 '70 '75 1977 *Four-year annual compound rate lagged by two years. Source: lbbotson and Sinquefield, Stocks, Bonds, Bills, and Inflation: The Past (1926-1976) And The Future (1977-2000)

(Charlottesville, VA: The Financial Analysts Research Foundation, 1977).



CHART IX Correlation of Expected and Actual Returns,

1952 to 1977

Actual 20 -

15

10 4

5 _ .

I I I- -10 -5 / 5 10 15

*.* I Expected i-5

I-

minishing over most of the period in which expected returns were positive and only began to increase at about the time such returns turned negative.

To those who view the behavior of financial markets as a manifestation of irrational human behavior, the consistency of these relations might seem astonishing. Nevertheless the evidence clearly implies that some very basic factors have had an important bearing on relative realized returns from stocks and bonds. While investor psychology may have distorted or deferred the significance of these factors over the short term, they have clearly prevailed over the long term.

Risk Premiums

In trying to understand the behavior of stock prices over long periods of time, it is important to understand that investors (in the aggregate) go through extended periods of improving or deteriorating confidence. The period from 1952 through the late 1960s may be charac- terized as one of improving investor confidence, while the period from the late '60s to the present may be thought of as one of deteriorating confidence.

In 1968, it would have been difficult to find any investor with much enthusiasm for fixed income securities. The returns from common stocks had been outdistancing the returns from bonds ever since the early 1950s. By 1974, however, the situation had re- versed. At that point, the returns from bonds and other forms of fixed income securities had been exceeding the returns from common stocks for several years. Today, investor attitudes toward common stocks appear mixed.

The level of investor confidence appears to be the primary determinant of the magnitude of the risk premium implicit in the level of stock prices at any given time. The factors that influence changes in investor confidence are the subject of untold hours of discussion (and debate) among investors and others. Fundamental shifts in confidence appear to result in part from investors' perceptions of general sociopolitical and economic developments-the same factors that enter into the political process, influence the way people vote and the kind of legislation that may be proposed by the Ad- ministration or actually passed by Congress-and in part from the effect of recent investment experience on investor preferences. More specifically, changes in the behavior of the economic system, the degree of financial leverage, the investment process, the tax treatment of ordinary income and capital gains and the structure of expected returns from common stocks have a lasting impact on the level of the implicit risk premium.

In trying to interpret the effect of such changes, it is helpful to start with some notion about what the implicit (forward-looking) risk premium has been in the past. The Ibbotson and Sinquefield data indicate that common stocks and corporate bonds have generated average annual returns of 9.2 per cent and 4.1 per cent, respectively, over the period from 1926 through 1976. We take the difference- 5.1 per cent-to be the risk premium for holding common stocks. It seems reasonable to assume that the implicit risk premium has also averaged somewhere around five per cent during this time. But there have undoubtedly been wide variations on either side of that figure; for example, the premium may have been 10 per cent or better in the early 1950s, and it was probably very close to zero in late 1968. How have some of the aforementioned economic factors changed to modify the historical norm implicit risk premium?

There is an enormous amount of literature on the behavior of the economic system, viewed in terms of the stability (or volatility) of final demand. Suffice it to say that stability encourages investor confidence, and that final demand has been more carefully managed during the past 30 years than at any previous time in U.S. history. While the past 10 years have witnessed some retrogression, it appears that deterioration during the past decade did not carry us all the way back to the conditions of the late 1920s, the 1930s and the 1940s. In general, despite the setbacks that have come with inflation, the behavior of the economic system appears to be more stable now than it has been on average during any time in the past 50 years.

The degree of financial leverage in the system, while not that great relative to certain other economies (notably Japan), has been historically high during the past decade. In general, fixed costs as a percentage of gross revenues have increased, most conspicuously in the case of borrowing costs, which have risen with the

36 C FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1979



increase in the percentage of long-term debt in the capitalization structure (particularly during the late 1960s) and with the higher interest rates introduced by inflation. Higher fixed costs mean higher depreciation charges and, perhaps more importantly, less flexibility for management, since variable costs become a less important segment of the total cost structure. If the detrimental effects of leverage are outweighed by the relative stability of the economic system, we would expect investor confidence to be on the rise and the risk premium to be on the decline.

Changes in the investment process include, most notably, the growing institutionalization of common stock holdings. During the past 30 years, institutions have come to own an increasingly high percentage of the universe of common stocks-more than 40 per cent at the present time. The accumulation of larger pools of equity capital has permitted greater diversification of individual holdings, and many institutional entities have a clear fiduciary responsibility to diversify. The result has been significant reduction in exposure to the specific risks unique to particular companies and industries.

The continuing institutionalization of the investment process should tend toward a decreasing risk premium since, as exposure to nonmarket risk diminishes with diversification, the market pricing mechanism should adjust to deny any prospective reward for that type of risk. This is precisely what the capital asset pricing model assumes. At a minimum, the magnitude of the risk premium should be less than it was in the days when the stock market was made up almost entirely of individual stockholders.

The tax treatment of both ordinary investment income and capital gains has been less favorable to investors during the past 10 years. Increases in the taxation of capital gains have placed the U.S. near the bottom of the list of major industrial nations in this regard. The effect on most individual stockholders has been significant. On the other hand, the impact on securities prices has been cushioned by the fact that an increasing amount of securities are being held by pension funds and other kinds of substantially tax-exempt institutions. In general, because of the numerous shifts in tax law and the significant shift in holdings toward tax-exempt institutions, it is difficult to judge what the net impact of tax treatment has been on the implicit risk premium.

Finally, the structure of expected returns from common stocks has changed a great deal during the past 18 to 20 years. Up until about 20 years ago, dividend income accounted for the larger part of total stock return. With the bull market of the 1950s and early 1960s, dividend yields gradually diminished to around three per cent per annum, while annual earnings growth rose to a fairly consistent five per cent. Divi-

dends became the smaller component of expected return and have continued so until the present time, with the adjustments to inflation having produced dividend yields averaging around five per cent and growth rates ranging between eight and 10 per cent. Since the uncertainty of return from capital appreciation is greater than the uncertainty of return from dividend income, this shift in the structure of expected returns would justify some enlargement of the implicit risk premium.

If we add up all the plusses and minuses, a range of four to 4.5 per cent would seem to be a reasonable approximation for the implicit risk premium. But, even if future market behavior validates this judgment, there are likely to be some long and wide departures from the norm, reflecting the kinds of shifts in investor confidence that have been characteristic of the past.

Looking Ahead

In trying to anticipate the performance of the stock market over the next 10 years, it would seem reasonable to start with some ideas about the pattern of dividend payments and the level to which they are likely to move over that period. First, however, it is necessary to consider what may be in store for the growth of the economy, both in real terms and on the basis of nominal GNP figures.

While the rate of inflation and the decline in productivity during the past decade do not provide a basis for much optimism, there are some encouraging signs. First, the decline in productivity may be in part a reflection of statistical measurement deficiencies. Second, inflation has become the number one political issue within the United States, and that is likely to bring about some ultimate relief. Third, there is growing recognition among economists, politicians and others that the monetary and fiscal policies applied in the past have stimulated demand more than supply, contributing to the inflation problem. Fourth, there is a major groundswell of interest in the restructuring of tax policies to encourage greater capital formation, which would enhance our ability to provide more jobs and allow for real improvements in living standards.

The balance between real growth and inflation may very well be more favorable (on average) over the next 10 years than the consensus view now holds. As mea- sured by the GNP statistics, real growth should develop at a rate somewhere between the average 3.9 per cent for 1956-66 and the average 2.7 per cent for 1966-76. On the other hand, inflation should average below the current rate of around 10 per cent-perhaps somewhere within a range of six to seven per cent. These two components combined would generate nominal GNP growth of nine to 10.5 per cent per annum. However, if we allow for the probability of two or three recessions during the next 10 years, the average rate is more likely to be eight to 10 per cent per annum,




producing a GNP of some five trillion dollars in 1988. Much more important from an investment

standpoint is the probable direction of corporate profits. For a variety of reasons, corporate profits suffered very badly from 1965 through the early 1970s. As noted earlier, business management was slow to recognize and to adjust to the inflation problem. In part, this may have been the result of a false sense of well being stemming from net income figures that merely reflected historical (rather than current) costs. In addi- tion, the periodic use of monetary and fiscal constraints and the imposition in 1971 of wage and price controls made it difflcult for business to adjust to inflation even when the need became recognized. More recently, an adjustment has been taking place. To reiterate, returns on book equity have been rising, and profits, when viewed as a percentage of GNP, have begun to recover some of their lost ground. As indicated at the outset, returns on book equity should continue upward and may well reach a new equilibrium point sometime within the next three to five years. Based on past experience, such an improvement in profits could well develop beyond the equilibrium point, at least for a while. Thus corporate profits could expand at an average rate of nine to 11 per cent during the next 10 years.

Most important from an investment standpoint is the prospect for dividends. The pattern of dividend increases in recent years has improved as profits have continued to improve, and the downward adjustment of dividend payout ratios appears to have been com- pleted in 1973. There are a number of reasons to be- lieve that payout ratios will continue to improve, at least moderately, in the foreseeable future. The first, and least important, reason is that dividend payouts usually improve in a recession year, and 1979 could be that kind of a year. Second, the expected improvement in corporate profits should help avert the kind of financial strains the system suffered during the late 1960s and early 1970s. These strains were a major cause of the lowered dividend payouts between 1970 and 1973. Third, dividends have become more significant as a stock price factor, and corporate managements know it. Managements will keep dividend payouts coming as long as they are at all consistent with sound financial management and capital requirements. Finally, the growing popularity of dividend reinvestment plans should contribute to higher dividend payouts.

The dividend reinvestment plans relevant to the future of dividend payout ratios are those involving the issuance of new shares by the corporation. There are a growing number of such plans, and a good many of them provide for the purchase of shares at a discount of five per cent from the going market price. With this kind of plan, the corporation can "have its cake and eat it too"-i.e., can enhance the price of its stock by paying a higher dividend, knowing that it will recover a

portion of the dividends through the issuance of new shares. Such monies can more than match the funds the corporation would have received had it lowered dividend payout and increased retained earnings.

Over the next 10 years, these various factors should produce dividend payout ratios higher than current ones, although not approaching the 52 to 53 per cent payout levels that prevailed prior to 1970. Ratios in the next decade might run somewhere between 43 and 47 per cent, perhaps finishing the decade at around 45 per cent. In combination with the projected increase in corporate profits, such dividend payout improvements could generate dividend increases in the area of 10 to 11.5 percent per annum. Given inflation of six to seven per cent, these increases differ little from the five to six per cent increases that were characteristic of the 1950s and early 1960s, when the inflation rate varied between one and two per cent.

Of course, while the rate of return on common stock holdings is significantly influenced by the dividend growth factor, its single most important determinant is the implicit risk premium prevailing in the marketplace at the terminal date. In trying to develop a 10-year forecast, the critical question is, what will the risk premium be in 1988? There is no way of knowing just where investor confidence will be at such a distant date, but we can project a "mid-stream" expectation, recognizing that the outcome may vary significantly to either side.

Curiously, the risk premium implicit in the current level of stock prices is probably very close to the five per cent historical average. The current expected return for common stocks represents the sum of the current 5.0 per cent dividend yield (S&P 400) and the current consensus of the future growth rate. Given the unfolding pattern of dividend payments, that consensus may now be around 9.5 per cent per annum (the approxi- mate average compound rate of dividend increases during the past five years). The 14.5 per cent expected return from common stocks provides a five percent per annum expected premium over the 9.5 per cent yield to maturity on corporate bonds for the additional risk involved.

Prospects for an increasing dividend growth rate and more favorable tax policies can be expected to increase investor confidence and to reduce the current risk premium. A risk premium of 3.5 to 4.5 per cent would seem a good approximation for the next decade. This is not very different from the 4.0 to 4.5 per cent range that was suggested as reasonable, considering the various changes that have taken place in the volatility of the economy, the ownership of common stocks, the taxation of dividends and capital gains and the composition of common stock expected returns.

Given these crucial assumptions about common stocks, and some equally important projections of cor-

38 Fl FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1979



Pension Fund Perspective continued from page 11

market on interim fluctuations. Some new bonds have short first coupons of only five months. Some long ones of eight months; others pay on June 30 and December 31.

Accruing interest on a large portfolio is a nightmare. The interest accrued on a single portfolio at the same point in time equaled $174,000 according to the former custodian, $127,000 by the new custodian's reck- oning and $153,000 according to an

independent performance monitoring system. Errors of this magnitude are common. Many people look at such discrepancies and decide not to use any credit for accrued interest rather than one that may be so wrong.

Finally, and most critically in this age of quantification, many major independent performance measurers ac- cept whatever return number trustees or managers feed them, some includ- ing accrued interest, some not, put them in the hopper and crank out rat- ings. Other measurers calculate accrued interest accurately and use it properly for all accounts. The majority fall somewhere in between. Unfortu- nately, the majority of portfolios mea-

sured fall into the first group, and the outcome is readily apparent: A single portfolio submitted to one performance measurement service-once by the investment manager, who included accrued interest, and again by the client's custodian bank, which didn't-ended up outdoing itself by two per cent.

To client and manager we offer three pieces of advice. First, know what is or is not included in the total return being calculated. Second, make some allow- ance when comparing a real world return with an index return. Third, don't compare returns calculated with accrued interest with those calculated without it. e

CHART X: Projected Common Stock Prices and Compound Rates of Return, 1978 to 1988

Current Conditions (October 1978)

S&P 400: Price - 113 Dividends - $5.45

Projected Conditions (October 1988)

Least Most Most Favorable Likely Favorable

1978-88 GNP (Nominal) 10% 9% 8% Growth Rates S&P 400 Earnings 11 10 9

S&P 400 Dividends 12 11 10

1988 Inflation Rate 8.0% 6.0% 4.0% Conditions Long-Term Interest Rate 11.0 9.0 7.0

Dividend Growth Rate 9.5 9.0 8.5 Dividend Payout 44.0 44.0 44.0

Stock Prices Risk Premium (1988) (Rates of 5.5% 241(14.2%) 280(15.2%) 352(17.0%) Return) 4.5 281(15.5%) 343(17.0%) 469(19.7%)

3.5 337(17.1%) 441(19.3%) 704(23.9%)

Note: Dividends growing at 11 per cent per year would reach $15.47 in 1988. The projected price of 343 is based on an assumed dividend yield of 4.5 per cent at that time. That dividend yield is the residual of the assumed discount rate of 13.5 per cent (nine per cent interest rate plus 4.5 per cent risk premium) and the assumed dividend growth rate of nine per cent from that point in time.

porate bond interest rates, it is possible to estimate the Industrial Average . * If so, the average compound total future level of stock prices and the compound rates of rate of return for the 10-year interval would be around return to be realized during the interim. Chart X pro- 17 per cent, which compares favorably with the rates of vides some estimates based on the range of projections return realizable from holding corporate fixed income around each key factor. The enormous impact that securities over the same period. The most basic tenet of seemingly small changes in the assumptions can have investment theory-greater rewards for greater risks on the final outcome is apparent. taken-would again be fulfilled. U

Our one "best guess" would be that the S&P 400 will be in the neighborhood of 340 to 345 in 1988, * Assumes the DJIA will be up only about 90 per cent of the roughly equivalent to a level of 2400 for the Dow Jones S&P 400.




developing a long-term outlook for the u.s. economy and stock market

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