13. A Primer in Understanding and Projecting Returns from Stocks and Bonds

Dated Jun 3, 2020; last modified on Sat, 12 Mar 2022

What determines the returns from stocks and bonds?

A stock buyer expects a growing stream of dividends. If the company re-invests its profits, the stock buyer expects more rapidly growing dividends in the future, or a lucrative stock buyback.

Long-run Equity Return = Initial Dividend Yield + Growth Rate

In the short run (e.g. a year) the changes in price/dividend or price/earnings multiples determine returns. In optimistic times, e.g. March 2000, P/E > 30 and P/D > 80. In times of pessimism, e.g. 1982, P/E > 8 and P/D > 17

Stocks and bonds compete for investors' savings. When interest rates are low, stocks tend to sell at low P/D but high P/E. When interest rates are high, stock yields rise to be more competitive, selling at low P/E.

The role of dividends is in question. Companies tend to distribute earnings through stock repurchases rather than dividend increases. Buybacks tend to create capital gains, whose taxes are deferred until the stocks are sold (or avoided completely if the shares are later bequeathed).

On the long run, bond yields can be approximated by the yield to maturity of the bond at purchase time.

When interest rates rise, bond prices fall to make existing bonds competitive with bonds currently being issued at the higher interest rates. Yields for investors who don’t hold to maturity are subject to interest rates rising/falling.

In the bond market, increasing inflation is unambiguously bad. Common stocks are, in principle, a hedge against inflation.