March 22, 2011
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
There appears to be an underlying consensus that we are likely to repeat another decade of no or low returns from the stock market. That’s not just my opinion or outlook, it’s collectively yours.
The stock market may not be predictable by the month or year, but its returns over a decade can be reasonably estimated based upon two key measures. This discussion pulls extensive excerpts from Probable Outcomes: Secular Stock Market Insights, the recently-released book about the plausible range of scenarios for the stock market and returns over this decade.
I’ll explore the implications of your outlook for those two key factors and the resulting probable outcomes for the stock market. Just as Bill Murray woke up to the same thing day after day in the movie “Groundhog Day,” it’s likely that your outlook foretells a groundhog decade for the stock market that will repeat its near-breakeven returns from the past decade!
Before we journey into outlooks and outcomes, let’s explore the principles behind the approach to this analysis and let’s put the two factors into perspective.
Two driversDespite the misunderstandings created by conventional wisdom and cheerleading analysts, the value of financial assets is fairly straightforward. First, financial assets are investments that return cash over time. Bonds, for example, pay interest periodically and principal at maturity.
Second, the value of a financial asset is driven by its future cash and the market rate of return. We can look at this two ways. If you want a certain rate of return, then there is a price to pay where the cash delivers that return. Analysts call this concept “present value.” Alternatively, since the market generally presents us with a price, each purchase represents an implicit rate of return based upon expected future cash. For bonds, this is called “yield-to-maturity.” The yield from a bond is often different than its interest rate because it is purchased at a market price that is different than its face value.
Compared to bonds, stocks are a bit more complicated. Unlike bonds that ultimately repay the face value, stocks don’t mature in the future. Most importantly, stocks have an uncertain future cash stream. Some stocks pay excess earnings as dividends, while others retain earnings to promote future growth. Regardless, the ultimate value of stocks as financial assets is driven by earnings and earnings growth. That is emphasized by the general acceptance of the price-to-earnings ratio (P/E) as the most recognized measure of stock valuation.
Therefore, the stock market has only two components of return for investors. The first component is dividends—excess cash from earnings paid periodically by some companies to their stockholders. The second component is capital gains—the difference between the purchase price of a stock and the sale price.
Capital gains come from two sources. The first is the growth in earnings per share. The second is any change in the valuation multiple as determined by the market. For example, if HotStock has earnings per share (EPS) of $1 annually and the market price of the stock is $20, then the P/E is 20. If EPS increases to $2 over time and the market maintains the same valuation multiple, then the stock will trade for $40. Conversely, if EPS goes up and the valuation multiple rises, then the capital gain will be even greater…or if the valuation level declines, the market price can reflect a loss even though earnings grew.
The key points to take-away are that (1) stocks are financial assets that return cash or gains over time, (2) their values are driven by earnings and earnings growth, and (3) their prices are determined by the market’s valuation multiple.
So what drives earnings growth and the market valuation multiple?
Earnings are the net result for a company after deducting all expenses and costs from sales. Sales generally are the result of production by the company. When we add the consolidated production (i.e., sales) of all companies together, we essentially get the economic measure known as gross domestic product (GDP). Although profit margins tend to rise and fall with the business cycle, earnings are ultimately driven by GDP. Therefore, GDP growth is a good proxy for the long-term growth rate of earnings for the stock market.
For the market valuation multiple, there are two factors. First, market investors are willing to pay higher values when earnings grow faster and, conversely, lower multiples when earnings grow slower. This has not been a factor historically, however, because the long-term growth rate in the economy has been fairly stable near 3% for more than a century. That encompasses most of stock market history. This is, nonetheless, a factor to consider now that some investors and analysts are beginning to wonder about the future long-term growth rate for the economy.
The second factor that drives the market valuation multiple is the inflation rate. When inflation rises, market investors price financial assets to reflect higher returns. This compensates for the loss of value to money caused by inflation. Further, during periods of deflation, the decline in prices over time, earnings growth becomes negative in nominal, reported terms. The result is that both deflation and higher inflation drive down the market valuation multiple (i.e., P/E). Conversely, P/E tends to peak when the inflation rate is low and stable.
The key points to take-away are that (1) economic growth (GDP) drives earnings growth (EPS) and (2) the market valuation multiple (P/E) is driven by the earnings growth rate and the inflation rate.
Would you like to send this article to a friend?Remember, if you have a question or comment, send it to .