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What’s in store for long-term stock market investors in wake of last week’s unnerving drop?

Charlie Farrell

Photograph by Ellen Jaskol

Charlie Farrell

You no doubt noticed that until last week the stock market was on a steady climb. By the end of January, the stock market was up over 35 percent in a short 24 months. While the goal of investing is to see price increases, the stock market has a nasty habit of taking back gains that aren’t supported by the fundamentals. We started to see some of that this week. To put the price movements into perspective, it’s important to understand what makes bull markets and why they usually unravel.

While most of the time the stock market’s moves seem mysterious, ultimately the value of the market will roughly reflect the amount of earnings that publicly-traded companies generate. If we go back over the last 90 years, we can see that for the companies that make up the S&P 500, their earnings have grown at about 5.5 percent to 6 percent per year. And the price of the S&P 500 has also grown at about 5.5 percent to 6 percent per year. (S&P 500 historical data on earnings per share was obtained from Robert Shiller, Yale University.)

So if the long term rate of earnings and price appreciation are pretty steady, why do we have periods when the stock market jumps 30 percent or crashes 30 percent? It’s because in shorter term cycles of up to 10 years, markets are influenced heavily by investor perception. Investors often are either too optimistic or too pessimistic. Why? I don’t know. It’s just the way humans as a group operate, and it hasn’t changed with respect to financial markets for hundreds of years.

For the last two years, we have been in the psychological throes of a classic bull market. The most important thing to understand is that bull markets are a combination of slightly improving economic numbers (which we have) coupled with rapidly expanding investor enthusiasm (which we also have). Of these two ingredients, investor enthusiasm is the most powerful and what drives the big gains. The slightly better economy and the earnings basically serve as the catalyst to rationalize higher prices.

For historical perspective, let’s look at the biggest bull market ever, which was from 1980 through 1999. The total return for the stock market compounded at about 18 percent a year for 20 years. But how much did actual corporate earnings grow during this 20-year period? Only about 6 percent. During that bull market, over 70 percent of the price gains from the stock market came from investor enthusiasm, or what folks in finance also call “animal spirits.” Then about 50 percent of those gains disappeared in the bear market that started just after the peak pricing.

This is what makes bull markets so dangerous. They are not supported by fundamental growth, they are supported primarily by enthusiasm. And when something causes this enthusiasm to wane, as it did last week, markets decline. The important point is they eventually decline back to the fundamental valuations supported by earnings. So if you know markets are getting expensive and they go through booms and busts, what are you to do?

First, if you haven’t been in the stock market much and feel like you’ve missed out, then consider shifting some money to stocks over the next few years. Just feather your money into the markets slowly to get up to the target allocation you want for stocks. That way, if stocks decline, you can buy in a little cheaper, and if they keep going up, at least you have started to participate. You’ll likely need stock returns to meet your long term goals, and waiting for the “perfect time” usually means you’ll be waiting forever.

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