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….

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