Why do we think that the stock market will always go up? Why has it gone up over long periods of time historically? For instance, let’s look at this graph:
Source: A Random Walk Down Wall Street
There is one theory that I have read about in the writings of respected authors like Jack Bogle and William Bernstein. It states that there are three main components to long-term stock market performance:
Part 1: Dividend Yield
Obviously, if your stock distributes 2% in dividends each year, then you will have a 2% contribution towards of return.
Part 2: Earnings Growth
If earnings stay constant, then all other things equal, one would expect the share price of your company to stay constant as well. If the earnings grow by 5% every year, then your share price will grow by 5% per year. Thus, earnings growth rate is a vital component of total return.
These two parts added to together are coined the fundamental return:
Fundamental Return = Earnings Growth + Dividend Yield
Part 3: Changes in P/E Ratio
The price-to-earnings (P/E) ratio is the price per share divided by earnings per share. In other words, it is how much investors are willing to pay for each unit of earnings. If they are willing to pay 20 times annual earnings, the share price of the stock will be twice as high as if they only paid 10 times earnings. This part is denoted the speculative return, as it has changed throughout history:
Speculative Return = P/E Ratio Changes
Adding these two up finally gives you:
Total Return = Fundamental Return + Speculative Return
Predicting Fundamental Return
Now, what if your portfolio was all of the stocks traded in the United States? This would create a connection between the growth rate of the nation’s Gross Domestic Product and the earnings growth rates of all US companies. In other words, the fundamental return is based on GDP growth. In turn, the GDP growth rate is connected to population growth and productivity per person.
Here’s my quick take: If you invest in a globally diversified portfolio, do you believe that the world’s GDP will continue to increase in the future? I believe that this is a very good bet, and is a major reason why I continue to invest in the world markets with very low management expenses.
Some bad news: Now, from 1950-2000, fundamental returns were 10%: 4% dividend yield and a 6% earnings growth rate. These days, the S&P 500 has a dividend yield of only about 2%. Earnings growth rate estimates are subject to debate, but they hover around 6% still.
Predicting Speculative Return
However, the speculative return has greatly contributed to the high returns of the last 25 years for the S&P 500. This is due to a great increase of the overall P/E ratio of the stock market in recent history:
Source: Bespoke Investments
In 1950, the P/E ratio was only 7. During the dot-com bubble, it was over 40. Recently, the P/E ratio was as high as 24. It is very unlikely that this huge increase will happen again. So what does the future hold if P/E ratio either stay flat or fall? This will lead to a zero, and quite possible negative, future speculative return!
Source: Little Book of Common Sense Investing, Exhibit 7.1
In my opinion, the fundamental return is still a solid reason why stock prices will go up on the long-term, especially if you are not investing only in one country or economy. Some people call it a belief in capitalism, that economic growth will continue and GDP will continue to increase. I simply believe the the passion and motivation of all the people out there, from Sweden to China to Brazil.
However, there is good evidence that you might not be getting that 8-10% annualized return that many investment calculators seems to guarantee. You have to look at all the sources of expected future return, and the possibility of P/E ratio contraction.
But wait, why don’t people time the overall market based on P/E ratio? Some authors do recommend this. The problem is that the P/E ratio can also vary wildly for decades (see above), and most people don’t have either the patience or cash to fully see it through. For example, historically this has meant staying out of stock for 15 years at a time.
Will the P/E ratio ultimately settle at 15? 20? 30? 10? I have no clue. As the saying goes – the market can stay irrational longer than you can stay solvent. If it makes you feel better, as of this week, the P/E ratio is around 16. So the future speculative return from this point is starting to look more promising.