Managing Expectations

My wife’s sister-in-law was in San Diego this week for a medical conference and came to stay with us for the week-end before heading back to the Northeast.  We got up this morning to 60 degree temperatures and skies that were grey and overcast.  By San Diego standards, it was a miserable day.  But had our guest been at home, it would have been a balmy and delightful day.  Since we expect better in San Diego and worse in the frozen north, the same event can be either a success or a failure – depending upon the context and our expectations.

The markets offer similar opportunities.   There are only three components to stock market returns:  earnings growth, valuation level changes (i.e., the change in the P/E ratio1), and dividend yield. Historically, the average annual stock market return of 9.75 percent has been made up of 4.10 percent earnings growth, 1.31 percent PE growth and 4.34 percent dividend yield.  Since PE10 is historically high (nearly 21 versus the historical midpoint of around 16; see here) and dividend yields are quite low at around 2 percent (see here, for example), it would be foolish to expect stock market returns over the intermediate term to exceed 4-5 percent from this point.  This chart from Crestmont Research provides additional detail.

We remain, since 2000, in a secular bear market.  As a consequence, we must manage our expectations and those of our clients accordingly. It won’t often be San Diego in the markets.  An overcast day with 60 degree temperatures should be seen as a really good day.  And, since secular bear markets are prone to extreme swings in both directions (cyclical bull and bear markets), when we get San Diego weather in the market, we need to take full advantage of it.


1 I use PE10, otherwise known as CAPE of Shiller P/E, as the better measure in this regard. More here.


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