Where Do Returns Come From?Submitted by InFocus Financial Advisors, Inc. on April 29th, 2020
Why do stocks go up? Or, maybe a timelier question: Why do they go down? The answer of course, depends on what time horizon or period you are asking. Short-term moves in the market are wildly unpredictable and can be driven by even the slightest change in headlines. We have plenty of those right now, evidenced by the existing market volatility. However, the longer the time horizon provides us with a clearer picture of what drives markets. Below you will find an interesting chart from the latest JP Morgan’s “Guide to the markets.”
Looking at the graph on the left-hand side of the chart, you can see various bar-graphs for different parts of the world. What each of those bar-graphs are comprised of is what exactly has driven market performance over the last 15 years. If you look specifically at the U.S., there are two main drivers of returns: earnings and dividends. Without making this too complex, the growth in how much companies earn and the amount of those earnings that are given back to shareholders translate into how much you can expect these respective markets to grow, over time. That makes sense, and as we say in the office quite a bit “The world is an efficient place.” So is the stock market. Companies stocks, over the long run generally will not appreciate if the underlying company is not growing its earnings.
With all that said, why does this matter? Well, as many of our clients know we have a rigorous research and evaluation process for the economic and business climate. Generally, if these environments are good, companies will find a way to continue to grow their earnings. That said, if stocks are appreciating without any projected earnings growth, then they are just becoming more expensive. You would not pay more for a stock if its price were going up without any projected earnings growth, would you? That can be an abnormality and mean buying stocks at higher than average valuations. You do not pay high prices for an asset expected to earn the same or fail to grow its underlying earnings. There is much more to that equation, but the bottom line is it requires periodic evaluation.
All this to say, can you expect stocks to go up in the future? Well, there is of course no guarantee of that they do and there is certain to be major bouts of volatility along the way. But if you subscribe to the theory that large publicly traded companies will grow their earnings over the next decade and continue to pay dividends, that may well be the case.