US stocks have well and truly dominated Australian stocks since the bottom of the market in 2009, with the S&P 500 up nearly 200% and the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) up around 60%. However, in my view, the Australian market has a good chance of outperforming over the coming decade.
It may seem counterintuitive, but long-term market returns are typically easier to estimate than short-term returns. This is due to the volatile and random nature of markets over shorter periods.
The legendary pioneer of index investing, Jack Bogle, recently estimated a return for US stocks of around 2% per annum for the next decade. The estimate is based on his simple formula:
Returns = Dividend yield + Earnings growth + change in valuation
The US market has a dividend yield of around 2%. This means that Bogle expects that any earnings growth will be offset by a return of valuations to more normal levels.
Research Affiliates provides estimates for 10-year returns using a similar model. They expect the S&P 500 to return 1.1% per year (after inflation) on the basis that the Shiller P/E is currently at 27, significantly higher than its historical median of 16.
Source: Gurufocus.com
The Shiller P/E is a modified version of the P/E ratio that uses 10 years of earnings and adjusts for inflation. No indicator is perfect, however, research suggests that countries which are cheaper based on the Shiller P/E generally outperform on average for the next decade.
By comparison, the Shiller P/E for Australian stocks is at 15, slightly below its historical median of 16.
Research Affiliates estimates real returns of 6.1% per annum for Australian stocks on the basis of the dividend yield (4.7%), growth estimate (1.3%) and a slight valuation boost (nominal returns would be 2%-3% higher, depending on inflation).
With the added benefit of franking credits for Australian investors, this is quite reasonable in my view.
It is worth remembering that these valuation metrics are largely determined by the biggest companies in the underlying index – i.e, the major banks like Commonwealth Bank of Australia (ASX: CBA) and miners like BHP Billiton Limited (ASX: BHP). Future returns for the broad indices will continue to be influenced by these companies.
Buffett's Model
Another metric worth considering is what Warren Buffett described as "probably the best single measure of where valuations are at any given moment".
Buffett's indicator compares the total market capitalisation (TMC) of stocks to the gross domestic product (GDP) of the economy within the context of its long run average.
Since Buffett first described it in 1999, it has proven to be a useful way for investors to gauge when to be greedy and when to be fearful.
The following chart shows that the ratio for the US market is currently quite high relative to its history.
Source: Gurufocus.com
While still well below the levels of the 1999 tech bubble, it is now well above its 2007 heights.
By comparison, the ratio for Australian stocks is far more reasonable relative to its prior levels.
Source: Gurufocus.com
After an impressive 25-year run of GDP growth, the Buffett model suggests that if Australia can continue growing its GDP, sooner or later, stocks will follow.
