A Review of John Bogle’s “Common Sense on Mutual Funds” – Chapter 2

This is a chapter-by-chapter review of John Bogle’s Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition*. As the series progresses, I’ll create an index of each chapter.

Chapter 2 – On the Nature of Returns

Chapter 2—if you can’t already tell from the title—looks at where market returns come from. We’ll start with stock market returns.

On page 51 of the book, Bogle lists three variables that determine long-term (a decade or so) stock market returns:

1. The dividend yield at the time of initial investment.

2. The subsequent rate of growth in earnings.

3. The change in the price-earnings ratio during the perioid of investment.

This makes a lot of sense when you think about it. The higher the initial dividend yield, usually the lower initial purchase price. The lower the initial purchase price, the greater the potential for future gains.

For example, if current dividend yields are 2%, earnings growth is expected to be 4%, and the P/E ratio is projected to go from 13 to 20 over the next ten years (4.4% per year), the expected return would be around 10.4% over the next ten years. Of course, that’s not what we’re looking at these days.

According to this week’s Barron’s, the S&P 500 has a current dividend yield of 1.98% and a P/E ratio of a whopping 86.2! Keep in mind that the P/E ratio is price divided by earnings. The earnings for the S&P 500 index have plummeted 46.10 to 12.83, while the index value has gone from 876.07 to 1105.98. That’s the reason for today’s massive market P/E. The only way for the market P/E to get back down to a more reasonable level (of say 15 to 18), two or three things have to happen:

Investment Return consisting of…

1. Earnings must increase

2. The index price level must decrease

and Speculative Return…

3. A combination of the two.

At the current level of 1105.98, earnings would have to increase to $61.44 to $73.73 in order to bring the P/E ratio back to a normal level.

Were the adjustment to come from the price level of the index, the value of the index would have to drop to between 189.45 to 227.34. Ouch!

There’s no doubt that with earnings as low as they are, that they are bound to recover somewhat. We just don’t know how much and how long it will take for them to turn around.

Anyway, back to the main point. If the dividend yield is currently 1.98%, corporate earnings are expected to grow at 6% (a number I got from the book), and the P/E ratio for the index is expected to drop to 25 (-22% per year…a guesstimate) over the next 5 years. The average rate of return for the index over the next 5 years would be -14%. Not very encouraging.

As far as bonds are concerned, the metric Bogle uses to predict future long-term (10 years) bond returns is simply the current yield at time of purchase. According to his research, the initial yield had a correlation of +.93 (+1.0 is perfect correlation) with the returns earned on bonds following the intial purchase.

Bogle goes into more detail than I can give you here. I gave you the basic points of the chapter.

Next, we’ll look at Bogle’s thoughts on asset allocation.

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2 thoughts on “A Review of John Bogle’s “Common Sense on Mutual Funds” – Chapter 2”

  1. S&P’s chief investment strategist Sam Stovall:
    The reason we’re trading at such an elevated P/E — currently 86 for the S&P 500, compared with the historical average of 16 — is that the most commonly used P/E ratio is based on earnings from the trailing 12 months. And in the fourth quarter of 2008 the S&P recorded its first loss ever in earnings. We don’t expect that to repeat itself.

    Using estimates for 2010 earnings instead of the trailing 12 months, it is a more palatable 21. So the P/E based on trailing earnings is a misleading indicator at the moment.

    Source: http://www.google.com/bookmarks/url?url=http://www.latimes.com/business/nationworld/wire/sns-ap-us-outlook-2010-stock-market,0,1298326.story&ei=c-ohS8vZGYjAoAPU96HaAg&sig2=8hBBb1D4BHAlzMBUXyUWnw&ct=b

  2. I’ve been using forward P/E a lot lately. It uses expected earnings for the coming 12 months to calculate P/E for the company. I know its not a factual number and anything can happen in the future, but I don’t believe current P/E tells the entire story either since earnings have been really beat down in the past 12 months. Between the two numbers you should get a good idea of where earnings are headed.

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