Through the first quarter of 2018, the post – WWII annualized, real (inflation-adjusted) compounded total return on the S&P 500 has been 7.57%. This is an extraordinarily high real rate of return, handily beating bonds, commodities, gold and real estate. It is especially impressive considering that real (inflation-adjusted) growth in US Gross Domestic Product over that same time frame was only 3.14%. Why did US stocks perform so well over the last 70 years and what was the source of such high returns?
The answer is somewhat complex but three of the most significant factors are:
- Real Earnings Growth
US corporations have consistently been able to grow their real (inflation-adjusted) earnings over time. Thanks to capitalism, businesses in the US and around the world have been able to innovate, compete, grow sales and increase productivity, which has translated into a growing stream of dividends and capital gains for shareholders. Real earnings growth has tracked the overall growth in US GDP very closely since 1946.
- Changing Valuations
A “valuation” is simply a way to measure how expensive stocks are, by comparing their price to some fundamental accounting value such as earnings, sales or book value. There are many different measures of valuation, but probably the most common is the Price to Earnings, or “P/E” ratio, which simply divides the price of a stock by one year’s worth of reported net income.
Beginning valuations matter a great deal to long-term realized returns. Why is this? Every time you make an investment, whether in stocks, bonds, real estate or something else, what you are really buying is a claim on a long stream of cash flows (dividends, interest, rent, etc.) to be delivered to you at some point in the future. The price you pay for those cash flows determines your eventual return, and a lower price is better (higher returns) than a higher price.
As it turns out, most measures of valuation were quite low immediately following WWII but are above historical averages today. In other words, investors are paying more for the same level of sales, earnings, etc., than they were in the aftermath of WWII. Looking back from today’s vantage point, this growth in valuation has been a significant driver of historical returns (beyond what you would expect from the growth in the overall economy.)
Why are valuations higher today than in the late 1940’s? There are a myriad of reasons, but it is likely a rational response by investors to some fairly recent developments, among them globalization (which reduces the cost of labor and increases the return to capital), a declining inflation rate (from 3-4% down to about 2% today), tamer business cycles (shallower recessions than in the earlier part of this century) and much reduced corporate tax rates, compared with the 1940’s and 1950’s, which has significantly boosted after-tax earnings.
- Positive Skew
The high historical returns of the overall US equity market obscure the fact that most stocks actually do not have returns that exceed annual GDP growth. In a fascinating paper released last year, Arizona State professor Hendrick Bessembinder studied the behavior of almost 26,000 stocks from 1926-2015 (nearly every publicly traded US company in that timeframe) and discovered that US stock returns are distributed anything but normally:
- Most stocks (58%) failed to outperform one-month Treasury bills over their lifetime.
- More than half of all stocks actually lose money over time.
- All of the gains in the stock market above Treasury bills over the last 90 years are fully accounted for by the top performing 4% (~1,000) of stocks in the database.
- Half of that outperformance comes from just 86 stocks out of the 26,000!
This is the definition of “positive skew” – that there is a lottery-like characteristic to investing in the equity market, because the vast majority of stocks (96%) turn out to be “losers” (i.e. underperform the overall market) and that all outperformance is driven by just 4% of stocks (the “winners”). The very top echelon of high performance stocks can have astronomical returns, but there is no way to reliably identify these stocks beforehand. This goes a long way to explaining the “mystery” of very high stock market returns and also why stock-picking is likely to be a frustrating strategy for most investors. A much better strategy is to own a diversified basket of nearly all securities, to ensure that you’ll own those that will truly drive future returns.
