The New Normal -- 4% Stock Returns?

If your retirement plan is based on the assumption that future returns will look like historical ones, it might be time for a new plan.

Stocks in the S&P 500 index returned a remarkably generous 12% a year, on average, from 1950 through 2008 -- even after losing 37% in 2008. After subtracting for inflation, that's an annual "real" return of more than 8%. Financial planners often counsel investors not to count on real returns of more than 6% or 7%.

Then there’s Bradford Cornell, who says that over the long term, real returns from here forward likely won't top 4%.

Cornell, an economist specializing in valuation, teaches finance at the California Institute of Technology, and before that taught for 28 years at UCLA. He testifies on financial damages in court cases -- former clients include AT&T (T) and DuPont (DD). He has written dozens of published academic papers and two books, including "The Equity Risk Premium: The Long-Run Future of the Stock Market" (Wiley 1999). In a new paper slated for publication in Financial Analysts Journal, he argues that stocks are set to provide long-term returns equal to their dividend yields, plus about 1% a year in real gains. Dividend yields have averaged a little more than 3% over the past 50 years, although they're now closer to 2%.

Earnings growth drives stock gains and economic growth drives earnings growth. According to Cornell, economic growth in developed countries, which hold almost all the world's stock-market value, faces strict constraints. From 1926 to 2006, the average real increase in per-capita gross domestic product (GDP) among 15 developed countries was 2.19% a year. Rates were strikingly similar from country to country. The high was Japan at 3.11% and the low was the U.S. at 1.42%.

Most countries have been converging on the lower rate of growth experienced by the U.S. It's the closest to what economists call steady-state growth, a point at which economic gains are won only through population increases and technical innovation. From today, long-run economic growth in developed countries will likely average no more than 2% per capita, reckons Cornell, and he calls that number optimistic, for two reasons. First, the accounting used for measures like GDP doesn't deduct for things like pollution and environmental damage, which are growing costlier. Second, the rate of technical innovation seen in the past might not be sustainable. Cornell notes that GDP growth attributable to technology has been largely constant since 1950, despite a ninefold increase in the number of researchers in rich countries, suggesting a declining marginal product of research.

Population growth will help, but its rate is in sharp decline, especially in rich countries, so expect it to add no more than one percentage point to economic growth, Cornell says. So that brings us to 3% economic growth, which would imply 3% growth in earnings per share and, accordingly, 3% stock gains. But we must subtract for the net dilution in the overall supply of shares that occurs over time, mostly as new companies sell stock. From 1926 to 2008, the rate of net dilution was about 2% a year. That brings us back to 1% economic growth, and 1% earnings per share growth, and 1% stock gains.

So how do we explain those fabulous stock returns since 1950? Cornell says they're mostly attributable to a decline in what's called the risk premium for stocks. The growth of mutual funds, discount stockbrokers and retirement accounts has caused more investors to become comfortable with stocks, and made them willing to pay higher prices to own them (otherwise known as demanding lower returns). In recent weeks I've written that stocks seem worrisomely expensive. If Cornell's right, I'm wrong, but the effect for long-term investors is the same. Either we're in for a big selloff followed by a resumption of generous returns or we'll move on from here, but in a world of skimpy returns.

Of course, savvy investors will still find opportunities. Cornell's analysis deals with average long-term returns. The market will still become unusually cheap or expensive for short periods. Some stocks within the market will prove to be better deals than others. Developing economies can achieve faster growth -- although the tiny supply of their outstanding shares means investors will likely continue to chase them to high prices, reducing future returns.

Mostly, the prospect of meager stock gains ahead suggests you should do three things that you're hopefully doing already. Shop carefully, demand dividends and keep your financial planning assumptions conservative.