We hope you are doing well. Here is a recap of market performance for the month of September and year-to-date:
So far this month, many stocks have declined, with the S&P 500 leading the way down. Small cap stocks have declined less than the S&P 500, while international stocks and bonds are essentially unchanged. Despite this decline, the S&P 500 remains the leader for the year so far with regard to stock investments. Bonds are also firmly positive.
Presumably, one of the main reasons you work with us is the desire to achieve attractive future returns on your investment portfolio, within your risk-tolerance level. It’s probably not a shock to learn that we cannot predict the future, so how do we make insightful investing decisions without knowing exactly what’s going to happen? Is that even possible?
Actually, yes, it is. Investment returns are not random. Because they have a basis in financial and economic activity, we can use some simple assumptions to help gauge what returns will look like, and use that information to increase our odds of selecting higher-return investments for you.
To illustrate, let’s imagine two hypothetical, publicly-traded corporations – Red Company and Blue Company. As you will see, this example is not designed to be realistic – the point is to show the main factors that drive investment returns. Essentially, we use this formula:
Stock Returns = Earnings Growth + change in Price/Earnings Ratio
Here are the three main takeaways from this example:
Earnings Growth Matters
- In general, if a company makes more money, it’s worth more; if it makes less, it’s worth less. The reason the stock market goes up over long timeframes is because company earnings also increase over time. In this example, both Red Company and Blue Company have increasing earnings over the 5-year period.
- Red Company increased their earnings from $1.00/share to $5.00/share and Blue Company increased from $1.00/share to $2.50/share, which is great news for the stockholders of these companies.
- Red Company has done better, but both companies are becoming more valuable over time. Therefore, both stocks should go up.
Stocks Don’t Always Track Earnings
- In this example, Red Company grew their earnings by 400%, but the stock price grew by 1,900%! Blue Company grew their earnings by 150%, but the value of the stock only increased 40%. In the real world, this happens all the time. Stocks can, and do, fluctuate well in excess of the underlying company financial performance. At different times, investors place different valuations on companies. In other words, the Price/Earnings (P/E) ratio in the market reflects how willing the market is to own the company – and this can change quickly and drastically.
Sentiment Matters A Lot
- Ben Graham, one of the most successful investors of all time, once said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” As we stated, and the example clearly shows, the two main factors that determine investment returns are earnings growth and the P/E ratio investors are willing to pay to own the stock.
- In the short run, the biggest driver of returns is the P/E ratio. If the market is optimistic, this ratio goes higher, increasing returns. Conversely, when the market is pessimistic (like during the financial crisis, or during the COVID panic), the ratio goes lower, decreasing returns.
- P/E ratios can swing significantly over months or years, but over decades there is much less fluctuation. High P/Es tend to decrease over time, and low P/Es tend to increase over time. So in the long run, the market weighs the actual earnings – which become the bigger determinant of long-term stock returns.
We want to select investments where both the earnings and valuations can grow – which creates higher returns. And the higher the current valuation, the less likely it can continue to increase in the future. Please reach out to your advisorif you would like to discuss this process or your accounts in further detail.