Financial Markets

The Economy is Good, So Why Are Stocks Falling?

“Don’t just do something, sit there!”

-John Bogle

Most available economic data suggests things are going quite well.  The unemployment rate is 3.7%, which is the lowest in 49 years.  Third quarter GDP came in at 3.5%, which solidified the best back-to-back quarters in four years.  US wage growth has had its largest annual gain since 2009.  The S&P 500 companies have reported a new record for earnings per share and are currently operating at record high profit margins.

It’s important to always remember that the stock market is a leading indicator.  Just a few years ago as the market continued to climb upward I remember people saying repeatedly “the market can’t keep going up like this, the economy is not doing well”.  Now that the economy is doing well, and the market isn’t, people are still confused.  If someone had this year’s economic data and S&P 500 earnings reports a year in advance, I just can’t imagine it would have helped them make additional returns.  The market hasn’t fallen because of bad economic news, but because people are willing to pay a lower multiple for stock prices today than they had been recently (more on this below).

We all want to blame someone for our portfolios declining.  People that don’t like the President will find a way to blame him, and people who don’t like Democrats will find a way to blame them.  The reality is the market is complex and there are millions of variables factored in.  Finding rationale for a market decline may help get you air time on CNBC, or sound smart while with friends, but it won’t help your long-term investment plan.

Many of my clients admit they realize the market is always unpredictable, but I cannot tell you how many times I’ve had the following exchange:

Client:  Mark, what is your outlook on the market?

Me:  No one can predict the market and any guess I have would be just that, a guess, and the same odds as a coin flip.  Therefore you shouldn’t value my prediction.

Client:  I know I know………but what do you think?

My thoughts are that over the very long haul, the return of the stock market is driven by a fairly simple equation, starting dividend yield + earnings per share growth +/- change in the earnings multiple.  The earnings multiple is commonly referred to as the p/e ratio.

The below table is from John Bogle’s book “The Clash of the Cultures:  Investment vs. Speculation”.  Bogle refers to the change in the p/e ratio as the speculative return.  What you see on the far right column is that over the full period earnings growth and dividends contributed 9.50% of the annual 9.60% return, while the change in the p/e ratio only contributed 0.10%.

The 40s had the largest combination of earnings growth + dividends of any decade, but there were 3 other decades with higher total returns.  You can imagine that coming out of The Great Depression, there was a whole generation of people who had shun stocks for the rest of their lives, and the speculative return was largely negative.

It’s fascinating that earnings growth in the 2000s decade was 11.30% better annually than the earnings growth in the 1930s, and the market return during the decade of the 2000s was worse than the decade of the Great Depression!

Over the course of a lifetime, I would not anticipate the speculative change of the earnings multiple to add or subtract much from returns.  If you’re trying to predict the next 30 years from here I would guesstimate about 7% a year from the market.  The current dividend yield is about 2%, and if earnings grow at the historical rate of 5% you’ll add those together for 7%.  But as you can see, the formula doesn’t work very well in the short run.

Any opinions are those of Mark Meredith are not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The S&P 500 is an unmanaged index of 500 widely held stocks. It is not possible to invest directly in an index. Dividends are not guaranteed and must be authorized by the company’s board of directors.