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Buffett, Gross and others have argued that it will be impossible for stocks to return more than 6-8% going forward. Their general argument goes something like this: GDP has grown by about 3-4% annually. Corporate profits as a percentage of GDP are unlikely to change dramatically, owing to competition, taxes, wage demands, blood-sucking litigation lawyers, etc. While dividend yields have fluctuated dramatically, dividends as a percentage of GDP have averaged a pretty constant 2%. Inflation has been anything but constant, but let's assume it will average 2.5% over long periods of time. Add 'em all up and you've got 3.5 + 2.0 + 2.5 = 8% nominal returns, or about 5.5% in real returns.

http://www.sscommonsense.org/page04.html

Important caveat: This model describes how the underlying value of the Wiltshire 5000 ought to change through time. It says nothing about how the market price might change. For the market to actually provide a real return of 5.5% going forward, valuation levels have to remain constant (or increase). If valuations continue to decline from what many still regard as lofty levels, then the actual return will be reduced accordingly. Is the market overvalued, and if so, by how much? Using history as a guide to proper valuation seems suspect to me, because for most of its history the U.S. stock market has probably been undervalued. And you can't ignore competing yields on debt instruments.

While it's probably impossible to know exactly how much the Market is overvalued (if any), it's relatively easy to calculate the annual costs of overpaying by 10, 25, 50, or 100% over different holding periods of say 5, 10, 20, or 30 years. So a 10% current overvaluation on a 30-year horizon is trivial. Any modest overvaluation on a 5-year horizon is not. Uncertainty with respect to possible overvaluations of <25% is tolerable over very long periods.

Holding Period
Premium 5 10 20 30
1.10 1.019 1.010 1.005 1.003
1.25 1.046 1.023 1.011 1.007
1.50 1.084 1.041 1.020 1.014
2.00 1.149 1.072 1.035 1.023

For investors who are concerned about actual portfolios, rather than theoretical indices, we can't forget about frictional costs. While it's probably possible for a cost-conscious investor with adequate capital to keep these down to 0.5% per year, my guess would be that the average investor is probably incurring frictional costs of 1.5-3.0% per year.

Adding all these things together, I can easily envision a decade or more of 0% net returns from diversified investing in U.S. equities. From that perspective, 3.75% return on real-return bonds looks pretty compelling. Becoming a professional short seller seems even more attractive.

The bull's rebuttal, anyone?

TA
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