The Black Box Theory of Stock Market Returns

Most people, including experts and even sometimes this blogger, use what I call the Black Box Theory of Stock Market Returns.  It isn’t really much of a theory.  The idea is that the internal workings of the stock market are basically mysterious and unknowable by mortals.  The best you can do is to observe what has happened historically to people who have put money into the box NYSE-Mod-Small and average their results.

So we find that the S&P 500 return has averaged X% over some number of decades and we conclude that over the long run that is what we will get from the stock market. You may not get X% in any given year, but you should expect to get that as an average over a long period, because that was the average over a long period in the past.

This is not an entirely unscientific approach.  It is objective and makes appropriate use of data.  But on reflection it should be pretty clear that it is not all that scientific either.  It lacks any sort of explanation of how or why the market returned X%. Maybe there was something that was driving the market up in the past that will not apply in the future. It’s possible.

My daughter has been growing an inch every three months for the past year.  Yet I am fairly certain that she will not be nine feet tall when she’s sixteen.  This is because I have a theory about what is going on that is more sophisticated than a black box. (I mean with regard to her height. The rest baffles me.)

It is true that understanding the stock market is not simple. The underlying economic value of stocks is a bit more subtle than some other investments.  Own a bond and you’ve got a contractually guaranteed series of payments in the future. There’s some risk that the debtor may not live up to his obligations, but the core economics are simple and there are clear bounds on how much the bond could possibly be worth.

Residential real estate is also relatively tangible. A house is valuable because you can live in it, or rent it to somebody else who will live in it. Finding the value of a house starts with finding the value of the right to occupy it, a fact so obvious it is a wonder anybody ever forgets it. And yet, arguably, a lot of our recent craziness was due to a lot of people ignoring the true economics of houses and resorting to a black box theory of prices.

A stock is a share in the ownership of a company, and companies are worth owning because they (tend to) make a profit. What you are buying when you buy a share in a company is a share of that company’s earnings.

Where it starts to get complicated is that you don’t typically get a check in the mail for your share of earnings. The stock may pay dividends, presumably representing only a portion of earnings, but the company may also retain earnings to invest in its business or buy back shares from the marketplace. However, in principle all three of these choices, dividends, retained earnings, and share buybacks, amount to the same thing.  As a shareholder, you are better off by the amount of the per-share earnings.

Of course, translating between earnings and the value of a share is not simple. But if earnings are ultimately the economic driving force behind the value of stock, then the long run returns from the stock market as a whole ought to be driven by long run growth in earnings.

From 1950 to 2007 the S&P 500 went up an average of about 8.2%.  (That’s price-only. With dividends included the average return was more like 11.8%.) And yet earnings for the S&P grew only at about 6.7%, based on ten year rolling averages. Put another way, stock prices grew faster than earnings, meaning that PE ratios, what investors were willing to pay for a dollar of earnings, had a long-term secular increase over the period.

I think that was entirely justified.  Stocks were too cheap mid-century and it makes sense that that was corrected. But, and this is a big but, this means that some of the returns predicted by black box theories are from the market correcting a problem that very well may be fully corrected by now.  Assuming that the stock performance of the last 57 years will be repeated is assuming that PE multiples will continue the same long-term growth, that investors will progressively pay more and more per dollar of earnings. I find that hard to believe.

Don’t get me wrong.  I like stocks and the stock market.  And I happen to think the market is cheap right now. But before giving advice to people to jump into the market with both feet it is important to have a view on how much investors can expect from the market that is more sophisticated than a simple average of the past. Professionals can and should do better. The stock market is not that much of a mystery.

Pre-teen girls, on the other hand….

No Comments

  • By IndependentOperator, June 9, 2009 @ 8:42 am

    Regulation of the market is also a constantly changing beast. To take the market behavior under one regulatory regime and assume you will get the same return in a completely different regulatory environment is pretty silly. I think most people know these caveats. The problem is, even cocktail-napkin retirement planning requires some number, and I guess that’s the best we have?

  • By Rick Francis, June 9, 2009 @ 12:24 pm

    It seems that economists would have tried to make market models… have you done a literature search? A Google scholar search turned up 1,400,000 results for “Review article stock market models”. The real question is… are any of these models more useful than the black box long term averages?

    -Rick Francis

  • By Rob Bennett, June 9, 2009 @ 12:29 pm

    This blog entry highlights a fundamental reality ignored in 90 percent of what you read about stock investing today –

    Our state of knowledge of how the market works is primitive.

    We all should stop talking about the “experts” and what they say. There is no such thing as an “expert” in this field today.

    There are two big drawbacks to pretending there are “experts” when there are not:

    1) Those who have come to be perceived as “experts” come to feel a need to pretend that they possess far more confidence in what they say than they really do possess — they become dogmatic and puffed-up and narrow and rigid, and, over time, dumb (because they have closed themselves off to new ideas in an effort to avoid exposure of their lack of genuine expertise; and

    2) The rest of us come to believe all sorts of truly dangerous things that are not so. Mark Twain once pointed out that it is not the things that you don’t know that do you the most harm but the things of which you are certain that just ain’t so.

    There are no investing experts today.

    There are no investing experts today.

    There are no investing experts today.

    When we can come to accept that reality, we will open up the possibility of beginning to learn the ABCs.

    I think that it is fair to say that the market is in the process of trying to teach us all this critically important lesson. And that it will continue dishing out what it needs to dish out to make the lesson take root in our collective consciousness.

    I wish we could all agree to stop forcing the market to have to work it so hard!


  • By Dave C., June 9, 2009 @ 2:35 pm

    If the “professionals” were not financially motivated to provide misleading information, I’d have more interest in listening to what they say. CNBC might as well be the Disney Channel.

  • By GPR, June 9, 2009 @ 4:04 pm

    Of course there are experts. Just like there are experts in String Particle Theory or Fluid Dynamics, or any system that is massively complex.

    There are professors and analysts and even the occasional blogger (representin’ the Curmudgeon, yo!) who are considered financial experts.

    The difference is that these experts don’t appear on 24 hour news channels, blogs or Borders bookshelves, where they are competing more for viewers than they are for being right.

    We’ve always had these charlatans, it’s just that their soap box is now bigger and better amplified. So we need to work harder to ignore them.

  • By GPR, June 9, 2009 @ 4:11 pm

    Below are Arthur C Clarke’s Three Laws of Prediction. I don’t think he meant predicting the stock market, but they seem relevant (and I thought it might be new to many of you who seem to have grown up reading Grahams’s books rather than sci-fi).

    1. When a distinguished but elderly scientist states that something is possible, he is almost certainly right. When he states that something is impossible, he is very probably wrong.

    2. The only way of discovering the limits of the possible is to venture a little way past them into the impossible.

    3. Any sufficiently advanced technology is indistinguishable from magic.


    And any magical “black box” system is very easy prey to fake experts. Think perpetual motion machines. Or political pundits.

    I think that expecting the stock market to NOT have these people is asking a whole lot.

  • By Jim, June 10, 2009 @ 12:33 pm

    There actually is a theory of how much stock returns should be if you take an MBA program.

    It is know as the cost of capital and, in theory, it represents how much investors need to be paid to buy shares in a company. It is the riskless rate of return (represented by Treasury bonds) plus a risk premium because stocks are way more risky then Treasury bonds.

    If, on average, investors can’t make more than they make on riskless assets, then they won’t invest, at least in theory.

    Of coure, calculating these numbers . . .

  • By bex, June 10, 2009 @ 3:15 pm

    So… your central argument is that it makes sense for the stock price of a company to rise in relative proportion to its earnings…

    I recall twice in my lifetime where people said that such ideas were “quaint,” both times it was right before a major market meltdown.

    So… the next question is, how do we know when the S&P 500 is growing too quickly? There are far too many economic incentives to lie there…

    Maybe the simple solution is a random polling of every economics professor in the country. Either a thumbs up, or thumbs down. Then track the changes in that number.

  • By Frank Curmudgeon, June 10, 2009 @ 6:31 pm

    Bex: Although I reserve the right to do so in the future, I am not at this time prepared to disclose my Grand Theory of Equity Market Valuation. My point about earnings is only that: 1) PEs had a secular long-term increase over the past 50+ years 2) That was probably justified 3) That trend cannot logically go on forever, as there must be some rational roof to PEs so therefore 4) Part of the black box returns we saw in the past decades is unlikely to be repeated.

    As for the survey of economists (which probably really exists somewhere, BTW) I would only use it as a contrary indicator: buy when they say thumbs down and go to cash if they get enthusiastic.

  • By Helen, June 11, 2009 @ 6:58 am

    Great post, Mr. Curmudgeon.

    The media bandwith devoted to stock information (think Larry Cramer et al.) greatly exceeds the relative proportion of time the average investor should spend thinking about it.

    Instead, Joe Sixpack should make sure he first has savings (c.f. investments), a positive monthly cash flow, and an emergency fund.

    I think the overhype may be part of the over-valuation. On the other hand, Joe owns a relatively small percentage of the stock market — it’s the big investment houses that own most of the capital, are most of the demand, and therefore set (for the most part) the prices.

  • By Rob Bennett, June 11, 2009 @ 8:06 am

    Although I reserve the right to do so in the future, I am not at this time prepared to disclose my Grand Theory of Equity Market Valuation.

    I once dated a girl who would often make comments of that nature in response to my repeated urgings for full and complete disclosure. At the time I would have described it as the most frustrating of experiences. Looking back on it all years later, I am better able to see where she was coming from.


  • By Frank Curmudgeon, June 11, 2009 @ 11:16 am

    Rob: I am not holding back. I have no Grand Theory, at least not yet.

    Helen: I actually think that Joe Sixpack drives a lot of the relative valuation of the equity market. Professional investors may determine the prices of individual stocks, but it’s amateurs who decide on the margin how much money the pros get to work with.

  • By Roger, June 13, 2009 @ 5:02 am

    Interesting concept. It does sound pretty accurate; there is a tendency to say that stocks will return ten percent (or some similar value) and go on from there. It’s good to think about what stocks actually are, and the fundamental factors that affect their prices.

  • By Isabella, December 27, 2010 @ 2:23 pm

    Rolling, Rolling, Rolling in a new year .

  • By How Stock Market Works, March 7, 2011 @ 1:08 am

    Internal working of stock market is really mysterious and unknowable..

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  1. Weekly Dividend Investing Roundup - June 13, 2009 | The Dividend Guy Blog — June 13, 2009 @ 7:03 am

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