MR. ARNOTT: A couple of reflections on long-term returns. We can break equity returns into dividend yield, inflation, growth in real dividends. And if we do that, we have about a 2.5% dividend yield plus historically a 1% to 1.5% growth in real dividends. It will be faster than that because of the earnings boom. So let's give the markets 2% to 2.5% there. Long-term inflation, if we assume 3%, we are not at double-digit expected returns. That gives us a number somewhere in the 7% to 8% range.
I would agree with Larry that there is a real expectations problem out there in the sponsor marketplace. That said, I would say the market strength of 1995 has been fueled by a combination of the earnings growth that Larry alluded to and the plunge in bond yields. I think the latter is by far the more important factor in the rally of 1995.
What does this do for us in 1996? Well, the markets already are discounting good earnings. The markets already are discounting lower interest rates. The prognosis for 1996 early on is fine. I think the markets are fairly priced today given the magnitude of the drop in interest rates that we have seen. But hold on to your seats the next time interest rates pick up. It's only five years since the Dow was at 2300.
MS. KETTERER: Of the explanations for this year, I would agree with what everyone has said. Rob referred to this - the bond market is really anticipating a slower economy and the stock market is obviously anticipating strong corporate earnings and something has to give.
What's going to keep the market afloat next year? We are looking for much more modest expectations in the domestic market return, say 8% to 9%. And that will have a lot to do with the fact that we think corporate earnings will be subdued relative to the past four years.
MR. WIGNALL: I think there is a misconception in the marketplace, and some of us already alluded to it. The big earnings growth was in 1994, not 1995. The year-on-year change of earnings has been slowing down throughout 1995. In fact, third-quarter 1995 S&P earnings were up only 8%. That's down from 20% in the first part of the year.
So the return on the stock market can really be attributed to rerating on the back of the bond market. The earnings acceleration is now behind us; earnings growth is slowing. If our view is right that the economy continues to slow for the first half of next year, I think we could go down to zero growth in earnings in the first half of 1996.
The S&P is on about 17 to 17.5 times reported earnings. That's pretty rich. So if we are going to have a further rerating, we are saying the S&P is going to 19 times earnings. These are big numbers. No matter how I look at it, you have to have an implausibly large rally in the bond market or a mysterious acceleration of earnings. Stranger things have happened. But I would say low single-digit returns at best from the market.
P&I: Below 5%?
MR. WIGNALL: Yes, maybe.
MR. ABRAMS: I think you guys are too pessimistic. You are right, the dollar is a little stronger than it was at this time a year ago, not a lot. It had its plunge and then it came back. In the third quarter of