Be Realistic on Your Stock Market Return Expectations !! ( Investment Return vs Market Return )

<from my bookshelf >

The behaviour of the stock market is inherently so complex that no single variable can predict how the market is going to behave next or what would be its future returns - at least not on a regular and consistent basis. 

Market swing like a pendulum from optimistic to pessimistic and occasionally overshooting which resulted in a panic situation.

In the long-run, corporate earnings and dividends have provided a steady underlying stock market return. 

These fundamentals of economics are the result of growth, productivity, and prosperity in our economy. Whereas emotional returns on stocks represent the impact of changing public opinion about stock valuations – again it changes from month to month and daily from optimism to pessimism, we called it PE returns.

As you may notice, I have a series of collection of “ The Little Book of XXX “ in my book list. For those unaware, the Little Book series by Wiley Publishing is a series of small hardcover books. Each entry in the series seeks to explain in layman’s terms a specific investment strategy and how an individual can execute that strategy.

My favourite book in the series was the one written by John C. Bogle “ The Little Book of Common Sense Investing “. 

As we know that John C Bogle is the founder and retired CEO of The Vanguard Group: an American investment management company based in Malvern, Pennsylvania, that manages approximately $3.6 trillion in assets. It is the largest provider of mutual funds and now the second-largest provider of exchange-traded funds (ETFs) in the world after BlackRock, with about $451 billion in ETF assets under management.

Of course, the main topics of the book are about “ Index Investing “ but there is another important message one can gain from the book which is about “ Investment Return vs Market Return “ in the long run.

In his book, he explained that “ the average annual total return on the stock was 9.6%, virtually identical to the investment return of 9.5% - i.e 4.5 % from dividend yield and 5 % from earnings growth. That tiny difference of 0.1% per year arose from what I call “speculative return “.

image credit to the little book of common sense investing

image credit to the little book of common sense investing

Total Market Return = Investment Return ( Earning growth+ Div Yield ) + Speculative Return (impact of P/E change )

 He further explained “ Stock market returns sometimes get well ahead of business fundamental ( as in the late 1920s, the early The 1970s, and the late 1990s). But it has been only a matter of time until, as if drawn by a magnet, they soon return, although often after falling well behind for a time ( as in the mid-1940s, the late 1970s and early 2000s ). In our foolish focus on the short term market distraction of the moment, we, too, often overlook this long history. Rather, the reason that annual stock returns are so volatile is because of  “emotions “ of investing.

Speculative Return by Decade

image credit to the little book of common sense investing

In Chapter 2, he also mentioned that:” Speculative return, compared with the relative consistency of dividends and earnings growth over the decades, truly wild variations in speculative return punctuate the chart as P/E ratio wax and wane . A 100% rise in the P/E, from 10-20 times over a decade, would equate to 7.2 % annual speculative return.

 Curiously, without exception, every decade of the significantly negative speculative return was immediately followed by a decade in which it turned positive by a correlative amount…. The quite 1910s and then the roaring 1920s, the dispiriting 1940s and then the booming 1950s, the discouraging 1970s and then the soring 1980s --- reversion to mean ( RTM ) writ large.”

Total Stock Return by Decade

image credit to the little book of common sense investing

“Despite the huge impact of speculative return – up and down- during most of the individual decades, there is virtually no impact over the long term. The average annual the total return on stocks of 9.5% has been created entirely by an enterprise, with only 0.1% point created by speculation.  “ as he summarized in this book.

The message is clear , in the long run, stock returns depend almost entirely on the reality of investment returned by our corporation.

Predicting Future Stock Market Returns

In May 2016, McKinsey & Co published a report forecasting a lower return of the stock in the coming decades and warn investors to lower their expectations. 

You may find the report here (click ).

But what about the “ speculative return “ which is driven entirely by “animal spirit “ and really hard to predict?

As the great British economist John M Keynes wrote 70 years ago “ It is dangerous .. to apply to the future indicative argument base on past experience.”

While we try to do the future stock returns forecast, one must be “realistic “ on long term stock return expectation which is very much correlated to “ corporate earning and economic activities “, and be “ aware “ of huge swing in “ speculative return “ from year to year or decade to decade and from optimism to pessimism.

So, What are your predictions of stock market returns in 2017 !!

Cheers!

Quote Of The Day :

“ Over time, the aggregate gains made by shareholders must of necessity match the business gain of the company. “ Warren  Buffett

“ The stock market is a giant distraction.” John C Bogle