Note: This post was first published in May 2020 and updated in July 2021.
The stock market is a complex beast.
This is not entirely surprising. In a way, it should even be expected.
After all, it’s a mechanism that allows retail investors like you and I take a tiny ownership stake in large multinational corporations like Microsoft and Amazon.
In other words, it’s bound to be complicated.
The good news is that you don’t need to understand it to take advantage of it.
Much like an airplane in the hopefully soon-to-come post-Covid days, you just need to take a seat, strap in and enjoy the ride.
Yes, there may be some turbulence along the way.
However, it’s still the best way to get from A and B, provided you don’t freak out and do something silly, like trying to bail when things get shaky:
That being said, it’s not unhelpful to know how long your journey will take, what with those comfy economy seats, slightly annoying masks, and recycled air.
It’s the same with your investing journey.
As much as you might enjoy it, you probably want to reach financial independence sooner rather than later. And along with your savings rate, stock market returns are the most important determinant of how long it will take.
But what exactly is it that determines stock market returns over time?
With the stock market behaving like a rabid dog all most of the time, I can’t blame you for thinking there’s some kind of a random number generator at work.
In the short run, you are absolutely right. There’s simply no rhyme, rhythm, or reason.
In the long run, however, there is a broad set of principles that guides the market’s performance – and helps explain just how quickly your portfolio will grow in size.
Deconstructing Stock Market Returns
At the most basic level, there are three core components that determine stock market returns over long periods of time:
- Dividend yield
- Earnings growth
- Valuation multiples
If you are like most people, coming across this kind of terminology probably makes your eyes glaze over.
But it doesn’t have to be this way.
No, it doesn’t have to be this complicated
So before I reach for the defibrillator, let me try using a real-life analogy most people can relate to: real estate.
Not because I happen to like real estate as an asset class – but because it’s the most intuitive way to think about it.
So let’s go with the flow and imagine for a moment that you buy a rental property for 100k.
You pay for it in cash and rent it out with a long-term (say ten years) horizon in mind.
Let’s see how this simple operation jives with what goes on in the stock market:
Return Component #1: Dividend Yield
Assume that once all the expenses are accounted for, you clear 4k in profits every single year, which you promptly use to fund your family’s annual holiday to Mexico.
You can think of the 4k as your dividend. The dividend yield on your investment is 4%, calculated as 4k divided by the 100k cash investment.
The stock market works the same way. If you buy 100k worth of shares that have a 4% dividend yield, you’ll clear 4k in dividends every year.
And unlike real estate, you won’t have any operating expenses except for taxes.
So far, so good.
Return Component #2: Earnings Growth
As it happens, you notice the rents in the neighbourhood going up 3% per year.
Despite being a nice and agreeable person (and ignoring whatever The Guardian might tell you), you realize that increasing your own rental rates by 3% is also fair and square.
As a result, your 4k of profits increase by 3% every year, enough to pay for a nice dinner and a few extra margaritas in that beachside cafe on the Mayan Riviera.
You can think of this annual increase as earnings growth.
As your rental profits grow, so does the value of your investment.
When you originally bought the place for 100k, you essentially paid 25 quid for every dollar / pound / euro of net profit (i.e. 100k divided by 4k).
Now that the rental income has gone up to 4,120 (i.e. up by 3%), you should be willing to pay 103k for it.
Yes, that’s a 3% increase – in line with earnings growth. And that is exactly why stock markets tend to go up with time.
Corporations increase prices (have you seen how much the latest iPhone goes for?), which increases earnings, which in turn drives stock prices upwards.
Where it can get a bit confusing is that sometimes companies choose to hold on to some / all of their profits.
Hopefully, they do so in order to reinvest in the business and grow their earnings even faster.
An analogy would be you forgoing your annual holiday, using the 4k to refurb the rental property, and increasing the rent by 10%.
In that scenario, you are looking at a reduction in dividend yield (i.e. component #1 above) offset by a corresponding gain in earnings growth (component #2).
And so it all goes, fine and dandy… except that it doesn’t.
Because there’s a spanner in the works called:
Return Component #3: Valuation Multiples
This one can be a bit complex, so let’s lean on a wonderful analogy by Benjamin Graham to help explain the concept.
Suppose that at some point, a chap starts showing up at your door every single day, offering up to buy your rental property.
It’s all a bit annoying at first, but he is harmless in every other way and you are not obligated to transact with him, so you let him be.
After all, isn’t it nice to know how much your property is worth in case you do decide to sell it?
With time, however, you notice the fellow has got a bit of a manic-depressive personality to him.
Some days he’s bright and cheerful. Feeling optimistic about the world, he offers you 120k for the property.
But the following day, he reads a headline in the newspaper that throws him off. Perhaps something happened in the Middle East, or a certain election didn’t go the way he expected.
Upset and disoriented, he shows up at your door and blurts out a price – but this time far less than 120k. Let’s say it’s 80k.
By definition, manic-depressive patterns are quite unpredictable. So this behaviour goes on and on and on.
Some days, the chap is prepared to pay 30 quid for every pound of rental profits (120k divided by 4k).
On others, he barely gets to 20 times (80k / 4k).
Whatever the case, the price he is offering is often disconnected from reality – which is that you continue cashing in 4k (and growing) of profits every single year.
Well, the stock market behaves in precisely the same manner.
Sometimes it’s feeling optimistic and assigns a high value to corporate earnings. Other days it’s nothing but.
Take the S&P 500 as an example.
The ~500 companies in the index generate earnings, year in and year out.
According to folks doing God’s work over at GS, the combined 2021 earnings of the index (including those companies that will lose money) will land at about $193:
As of this writing, the S&P 500 index stands at roughly 4,347.
Thus, the implied valuation multiple is 4,347 / $193 or roughly 22.5 times for every dollar of underlying earnings.
For comparison, when the S&P went all the way down to 2,300 last year, stock market investors were only willing to pay ~16x (2,300 divided by $142 In 2020 earnings) for every dollar of earnings.
As you can see, there are two things that are happening here.
One is the variability in underlying earnings, which depend on economic conditions but ultimately go up in the long run.
The other one is the earnings multiple being assigned to those earnings, which oscillates widely over time:
S&P 500 Price – Earnings Ratio For The Past Decade
When you zoom out and look at it over longer periods, you can see that the ratio fluctuates within a certain range, but fluctuations can be wide-ranging – and unexpected:Long-term Evolution Of The S&P 500 Price – Earnings Ratio
Adding It All Up
You can see that if the chap in question stock market wasn’t so manic-depressive, figuring out your investment returns would be very easy.
Take the 4% dividend yield, add the 3% earnings growth and voila – you’ve got yourself a nice and respectable 7% return.
Unfortunately, in some years (i.e. 2019), the stock market feels absolutely exuberant.
Valuation multiples go up, the stock market rumbles ahead – and your return ends up being way ahead of 7%.
In 2020 other years, it’s the reverse.
The skies are dark, everyone is moody and valuation multiples tank. No dividend yield or earnings growth will save you.
Prices hit the gutter overnight, and you wish you never logged into your brokerage account to begin with.
And then, the clouds part, and the sun shines again in 2021.
Yes, there are nuances to the description above.
Both dividends and earnings growth fluctuate over time. And instead of going to Mexico, you’ve got to reinvest those dividends to buy more stocks.
Then there are the long-term secular trends that may cause valuation multiples to head in one direction or another for prolonged periods of time.
Part of the reason the US stock markets have knocked it out of the park over the past decade is the expansion in valuation multiples from c.14x to ~22x today.
Some of that has to do with market exuberance, in addition to the fact we have a much higher proportion of tech stocks in the mix these days.
But in the long run, it all averages out.
Dividend yields are largely dependent on the composition of the index you are investing in.
Indices that have more growth stocks (i.e. S&P 500) have lower dividend yields but higher growth rates.
Indices with a higher proportion of dividend-yielding stocks (i.e. FTSE 100) have higher yields – but lower growth as they reinvest a lower proportion of their earnings into the business.
But no matter the case, the answer stays the same: long-term stock market returns depend on dividend yields and earnings growth rates.
Yes, the stock market can lose its shit composure at moment’s notice, depressing the price-earnings multiple at a given point in time. But in the long run, it doesn’t matter.
No matter how helpful it may seem, successful investors learn to ignore that manic-depressive fellow showing up at their door every single day.
If you want to join them, you’ve got to do so as well.