Analyzing the Long Term Total Return on Stocks

Apples and Oranges
    You've probably read that the long-term total return on stocks since 1926 is
10.6%. That's true, but it's possibly just a little misleading. The problem is that the Dow Jones index in 1926 was only about half as high as it was just before the crash in 1929. We'll do better if we compare stock market values in 1929 with values at comparable peaks in later years. When we do that, we find that comparing 1926 with today's peak values has erroneously contributed about 1% to the commonly-quoted stock market return. Subtracting that, we get 9.6% for the total stock market return from its peak in 1929 to a comparable peak today.    

The Role of Consumer Price Inflation
    The consumer price index in 1999 was almost exactly 10 times what it was in 1929. That means that the value of the Dow, which crested at 381 in 1929, would be equivalent to about 3810 today. (Notice how close this is to today's Dow Jones numbers. The Dow didn't cross 3810 until 1994. If we had bought stocks at the peak in 1929, we wouldn't have gotten our money out of them until 1994! So much for buying stocks and holding them until the appreciate!) We need to correct our total return percentage  for inflation.
    The natural logarithm of 10 is 2.302. Dividing 2.302 by the 70 years between 1929 and 1999, we get an average inflationary rise of about 3.3% a year.
3.3% from 9.6% gives us a real (inflation-corrected) rate of return of 6.3%. This is the real rate of return that you could have gotten if you had purchased a market-basket of stocks at the peak in 1929 and had held them until a comparable peak in the 90's. That peak would have come during 1996, when the Dow reached 5600. And that gets us back into our discussion of apples and oranges. Stocks are sold at auction, and their prices go up and down as they're bid up during a rising market, and are dumped at fire sale prices during a falling market. Generally, their prices fluctuate over a 3-to-1 range depending upon whether stocks are hot or are not. However, by 2000, stock prices had reached price levels (as measured by two of the three common indicators used to tell  whether a stock is overpriced) never seen before in the history of the stock market. (Note: the peak value reached by the S&P 500 (on March 24, 2000) was 1527.46.

How to Tell Whether the Stock Market is a Good Bargain or is Too Expensive
   The three price ratios used to evaluate the "priciness" of the stock market are
Average Price-to-Book (P/B) Ratio
    The average price-to-book ratio is the average price of the stocks that comprise a stock index... e. g., the 30 stocks that make up the Dow Jones collection of stocks, or the 500 stocks in the S&P 500... divided by the average value of these companies if you liquidated them. For example, some firms such as forest products companies own a lot of valuable timberland. Their property, if sold, might bring in more money than the total value of all their stock.
    The average price-to-book ratio typically varies from
a little less than one when stocks are at the bottom end of their price ranges to nearly three-to-one when they're at the top. At this last stock market peak in early 2000, the average price-to-book ratio exceeded six-to-1!
Average Dividend Yield (D/P)
    Like the price-to-book ratio, the dividend yield also varies over a three-to-one range, from about
7% at a market trough to about 2.6% at a market crest.
    Dividend yields are lower than bond or money market yields because dividends will keep up with inflation, whereas bond and money market yields won't.
    During this last market top, dividend yields dropped to an unheard-of
Average Price-to-Earnings (P/E) Ratio
    The price-to-earnings ratio is the number of dollars you'll have to pay for a stock for every dollar of income it earns. Price-to-earnings ratios also ebb and flow with the stock market, but they also depend upon where the economy stands in relation to recessions. When the economy is coming out of a recession, companies can have anemic earnings, and high price-to-earnings ratios, without being overpriced. Later in the bull market, a high price-to-earnings ratio may signal an overpriced stock. Price-to-earnings ratios on the Dow and S&P 500 stocks swing from about
7:1 at the bottom of a recession to about 22:1 at the top of a bull market.
    Other factors enter into price-to-earnings ratios such as the rate of growth of the company. One rule of thumb for the price-to-earnings ratios of companies is that their P/E ratios shouldn't exceed their annual growth rates. This means that a company that is growing at a 40% per year rate could carry a P/E ratio of 40.
    During this last bull market, although the P/B and D/P numbers went into record territory, the P/E ratio was the one indicator that didn't go out of bounds as the stock market rose. The reason for this may be something called "return on equity"... the ability to get much more out of corporate corporate resources than was done in the past.

    Returning to the subject of total returns on stocks, the alleged 6.3% rate of inflation-corrected returns on stocks from 1929 to 1999 must consist of two terms: dividend yields and the slow rate of rise of the Dow Jones index after correcting for inflation. If we take 5600 as an appropriate peak corresponding to the peak at 3810 in 1929, then the average rate of rise of the Dow would be only about 0.55% per year!
    What these facts tell us is that for the blue-chips that appear in the Dow Jones Index and in the S&P 500, there are virtually no capital gains returns over time. The only real returns on these investments come in the form of dividends!
    Also, I don't arrive at a 10.6% or 9.6% total rate of return for stocks.

(More to follow)

Warren Buffett on the Stock Market - Fortune