Why Stocks Go Up
AIKEN, South Carolina – A headline yesterday…
“Wells Fargo: There is a 23.5% chance of a recession in the next six months.”
We disagree! The odds of a recession are clearly 23.6%, not 23.5%.
What are the chances that The Donald will win the White House?
What are the odds of rising stock prices in 2016?
What percentage of this is nonsense?
Hairdressers should not be allowed to use jackhammers on their customers. Bakers shouldn’t put explosives in their ovens. And economists should not be allowed to touch numbers.
It’s just not safe. If they’ve got anything to say, let them say it in words. Readers can judge for themselves if they have any value.
Numbers are wrong approximately 82.7% of the time. The rest of the time, they are just misleading. Or worse: They act like they know something you don’t. Or something you wish they didn’t.
“Your blood pressure is too high,” says your doctor.
“You’re drinking too much,” says your wife.
“You’re losing money,” says your accountant.
Each one backs up his claim with numbers.
But numbers can be useful, too; if you don’t take them too seriously.
Our own Agora Economics 10-Year Market Forecast, for example…
Put together by our chief researcher, Stephen Jones, this forecasting model is based – with some twists – on Warren Buffet’s favorite indicator: market cap to GDP.
And it calls for a real (inflation-adjusted) annual total return of negative 7.9% for the S&P 500 over the next 10 years.
Hey… that’s better than it was a few months ago. And for an obvious reason: Stocks have already suffered part of the loss projected for the next decade.
But does this mean that if you invest in stocks, you will lose 7.9% each year?
No, of course not. It just shows – with immodest precision – the results of our quantitative analysis.
We could put the message more modestly, in English, by quoting a former president of the USA: “This sucker is going down.”
Numbers can also be useful for making comparisons.
A long time ago, we teamed up with Mark Hulbert. Our goal was to put numbers to the relative performance of investment newsletters. We wanted to see who was making money for his subscribers… and who wasn’t.
Mark has been totting up the numbers ever since. But now, 36 years later, the performance cop is leaving his beat. Mark has retired from Hulbert Financial Digest.
What did he learn? In his farewell issue, he tells us:
The first, and perhaps most important, lesson to draw… is that it is very difficult to beat the market over the long term. Not just very difficult, but extremely so.
The best you can hope for is beating the stock market by an annualized average of just a few percentage point. This is crucial since it defines the risks and rewards of trying to beat the market.
Mark has been following, tracking, and calculating the performance of hundreds of newsletters over more than three decades. During that time, his best performer beat buy and hold by just 3.7% a year.
A doormat spotted here in Aiken shows a picture of a pistol with the words “Nothin’ in here worth dying for.” We wouldn’t want to get killed in the investment markets either… not for a paltry 3.7%.
Another friend, former White House budget director (under President Reagan) David Stockman, believes investors are going to get walloped by some very special numbers in the next sell-off.
He calls it a “fatal, technical flaw” in the market. He did a special webinar broadcast on the subject Wednesday night. But he is making it available as a special rebroadcast for Diary readers. You can sign up here.
Meanwhile, as it’s Friday, here’s an essay from the archives…
Beside the Still Water
Originally published July 30, 1999
This series of notes has been inspired and informed by Peter Bernstein’s book on risk, Against the Gods.
It is a rumination – written on summer vacation, in a lakeside cabin in Nova Scotia – about the odds of making money in the stock market.
As we waded in, we discovered that the water is much deeper than we thought… and much more full of rocks and tangley things that seem to wrap around our ankles and pull us down.
So far, we’ve seen that what most “investors” are doing is not investing. Investing is an activity that requires work, careful research, and close study.
No one can know what the future will produce, so investors reduce uncertainty by learning something about the businesses in which they invest… and investing in businesses where reasonable assumptions may be made on the basis of genuine, knowable information.
The more they know, the less risk they face.
None of this is possible, of course, with dot-com stocks, where nobody knows anything. And there are no solid numbers.
But if “investors” aren’t investing… what are they doing?
The answer: some form of gambling or speculation.
This can be a winning proposition, too… but only if you have an edge and know how to use it.
Most of the time, gambling is merely a costly entertainment.
A zero-sum game (meaning one person’s gain is equivalent to another’s loss) with even odds makes no sense – except for amusement.
You will win as often as you lose. And thanks to the principle of declining marginal utility, a dollar won is not as valuable as a dollar lost.
And even with the odds in your favor – you will still lose money unless you manage your bets shrewdly.
That said, the stock market is not the same thing as a casino. There are times when the wind is to your back rather than in your face.
And insofar as stocks reflect economic activity… the stock market is not a zero-sum game.
The economy grows; the companies in it grow and become more valuable, too. Even the most pathetic little dinghy will rise when the tide comes in.
And when the water is rising, even investors for whom the only Graham in their lives is in a box of crackers can still make a buck or two. All they have to do is to buy a broad assortment of stocks.
Fortunately for all the magnificent brokers’ yachts, as well as the pathetic little rowboats moored nearby, stocks go up often enough to keep hope alive.
In fact, they’ve gone up with such tedious regularity for nearly two decades that one might be excused for thinking they only go up. It is as though this tide goes in only one direction.
Why Stocks Go Up
But regularity is not the same as reliability.
The U.S. experienced an economic boom for 62 years after 1867… interrupted by only two years of backpedaling.
This boom was so persuasive, most investors in 1929 expected the good times to return very quickly. Alas, that did not happen.
Value investors Benjamin Graham and David Dodd proposed a reason why stocks “normally” go up. They said it was because companies tend to pay out less in dividends to shareholders than they earn in profit.
This accumulated income increases the capital value of the company — which is reflected in the share price.
Thus, when analyzing a stock, a reasonable investor should add in a small expectation of a capital gain to the expectation of a dividend… and compare the total return to what might be expected from a bond or other investment.
You don’t even need a calculator to do this math. If, say, stocks are averaging about 2% earnings, they may be paying out about 1% in dividends.
We might assume that they’re compounding the 1% not paid out… and that it will be reflected in the capital value… and hence the stock price… someday.
Thus, we might expect a total return of what… 2%?
What the heck…. This is a new era… 3%!
A Rising Premium
There’s another reason why investors can expect a capital gain.
In 1938, economist John Burr Williams calculated the “equity risk premium” at 1.5%. This was the annual return stock market investors could expect to earn above what they could get from supposedly “risk-free” Treasury bonds.
This premium was supposed to compensate them for the extra risk of owning stocks. Today, some economists are putting the risk premium as high as 8% – which makes stocks almost irresistible.
The latest figure I’ve seen [in 1999] is that investors expect 15% a year for the next five years from all stocks. Possible? Maybe… They should get 2% or 3% from earnings and retained earnings… plus another 5% to 8% from the equity risk premium… not to mention what they’re getting from incoming tide.
But the numbers are all nonsense. Stock market investors now believe the market always goes up… and they also believe that they get paid for the risk that it goes down.
Of course, no one can predict the future. And if the stock market goes into reverse, there will be plenty of “reasons” to explain that, too.
So, forget the reasons. Forget the numbers. Let’s look at the odds.
Even though the stock market is not a zero-sum game, it sometimes bears a closer resemblance to a casino than an investment exchange.
That is what happens when “investors” begin treating their investments like poker chips, when they forsake investing and begin speculating.
They gamble with no sense of the odds… under the delusion that they are “investing”… and that they are paid for taking non-existent risks. That is when the risks suddenly appear.
Bernstein describes a similar situation. There are “moments,” he says, “when the laws of probability are forgotten.”
He discusses the “Nifty Fifty” market of the late 1960s, when the perceived risk was not of overpaying for these 50 popular large-cap stocks but of not owning them:
The growth prospects seemed so certain that the future level of earnings and dividends would, in God’s good time, always justify whatever price they paid.
This view reached such an extreme point that investors ended up by placing the same total market value on small companies like International Flavors & Fragrances, with sales of only $138 million, as they placed on a less glamorous business like U.S. Steel, with sales of $5 billion.
I’m sure I don’t have to point out that $138 million in sales compares favorably with many of today’s billion-dollar dot-com companies, which have no sales at all.
The prospect of profits was dazzling. But the probability was slight.
Like today’s valuations, they required a number of things to fall into place. And each component in a chain of probabilities is multiplied by the previous one… rendering the odds of the desired event exponentially remote.
Hope of Heaven
Imagine that a new technology might have a 25% chance of “catching on.”
Imagine also that the company that you are buying might have a 25% of being a market leader with that technology…
Imagine, too, that there may be only a 25% chance that this new company… with its new technology… will figure out how to make a profit from it.
What, then, are the odds that you have bought a profit-making company with a credible new technology?
About 1 in 66.
Stock market bulls will counter that the market usually goes up… so the odds that it will go up in any given year are good.
But the market is not like a pair of dice in which each toss is independent. Instead, it is a natural feedback loop; the odds against each succeeding bull market year accumulate. But for our present purpose, we will assume the question is simply unapproachable by the laws of probability.
Since you can’t know whether the stock market will go up or down… you are in a position not too different from French mathematician and philosopher Blaise Pascal when he tried to prove that God exists.
Ultimately, there is no way to know. But like the difference between bull and bear markets, there were only two possibilities: Either God exists or doesn’t.
So, Pascal measured the cost of one decision against the other….
If he believed that God existed and he led his life accordingly, he may be disappointed for a few years. But if he led his life as though God didn’t exist… and it turned out he was wrong… he would surely roast in hell for eternity.
Since the latter cost was higher than the former… and the odds were unknowable… he had little trouble deciding the issue.
The hope of Heaven is the hope that people will get what’s coming to them. Only God knows what that is. Maybe the market will go up. Maybe it will go down. You can think what you want. But what are the odds?
Perhaps. But my bet is that in the Vegas-style market, there’s a lot more Hell below than Heaven above.
P.S. The dot-com bubble peaked on March 10, 2000 – less than a year after I warned readers. The Nasdaq dropped nearly 80% and didn’t recover until 15 years later. Could a repeat of this happen in 2016?
To find out why and how, tune into a special rebroadcast of my friend David Stockman’s webinar. Watch here now.