It seems that almost every day I read an article on an investing website indicating that the stock market is going to suck for the next 10 years, that we are in a “New Normal” for sub par investment returns, and other similar prognostications.  Both of the above links will take you to articles describing well-known and highly respected money managers.  The first article is current whereas the second is from June 2009.  The S&P 500 has doubled since that June 2009 article, but that hasn’t stopped Bill Gross from continuing to say that we are in a New Normal and that we should not expect the historical U.S. stock market return of approximately 10% to continue.

I will save any in-depth economic and investing theory for another article, but I want to make the point that the articles, and the concepts in general, are in some ways both right and wrong.  They are right based on the idea that at an elevated price-to-earnings ratio for the U.S. stock market compared to its historical average, the stock market as a whole is unlikely to increase in price at the same rate as it has in the past, from the current price.  This is particularly likely because we are in an earnings recession, meaning that U.S. publicly traded companies in the aggregate are experiencing a decrease in earnings.  With a decrease in earnings, the “E” (earnings) part of the price-to-earnings ratio will cause the ratio to get higher, not lower, even if stock prices stay the same.  Right now, the S&P 500 has a P/E ratio of 23.75 compared to its historical average of 15.6 (source: multpl).

On the other hand, stock prices do not stay the same.  As we have already seen this year, the stock market can decline 10% or more, sometimes without a corresponding decrease in earnings.  Such stock market swoons happen quite frequently, and can be much more severe than just 10%, as we saw in 2001 and 2008.  It is almost inevitable that at least once every year or two, the stock market will dip, the price-to-earnings ratio will become more reasonable, or even favorable, and from that low point, the stock market will not “suck”.  Of course, this leads into a host of other topics, such as behavioral finance, high-frequency trading, passive versus active investing, and momentum investing among other things, all of which I hope to discuss in the coming weeks.

So while these articles are catchy and depressing, they are written such that at some point in time, the prognosticator is going to almost definitely be right…”look, I said 5 years ago that we are only going to average a 5% rate of return, and as of today, we are exactly at that level, aren’t I a GENIUS!”  On the other hand, there will most likely be some time every year that the prognosticator will be wrong, and possibly very wrong.  As a result, even if we are in a New Normal, I think there will continue to be opportunities to find quality companies at discount prices, and I aim to help my clients navigate these opportunities.

-Richard

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