Returns depend upon the starting and ending point.  This series of charts presents the compounded annual returns for an investor that began investing during any start year since 1900 and ending with any subsequent year.  The versions presented reflect those for taxpayers and for tax exempt or deferred investors, as well as returns on a nominal and real (after inflation) basis.  The charts are scaled for printing on a single sheet of 11x17 paper or on two 8 ½ x 11 pages for subsequent alignment.  See the assumptions and legends for important details.

The stock market has demonstrated longer-term secular bull and bear cycles.  Secular cycles are extended periods with a common trend.  In the stock market, these secular cycles are driven by trends in the P/E ratio.  This chart presents the secular stock market cycles since 1900 based upon Crestmont’s research and analysis of P/E ratios, inflation, and other factors.  The cycles correspond with peaks and troughs in P/E ratios, often over extended periods of years.  The P/E ratio cycle appears to correspond with inflation cycles as they move toward periods of price stability (low inflation).  A version of the secular chart overlaid with detailed explanations of its key features is also available: Annotated Chart.

Although the compounded average annual change in the stock market is near 5% over the past century, the range of dispersion in annual returns is dramatic.  This chart presents the distribution of yearly index changes within the single digit range of -10% to +10% during the past century overall and during the secular bull and bear cycles.  In addition, a second range was determined to include half of the years within the range and half of the years outside of the range.  More than 50% of the years ended with changes in the index exceeding +/-16%, either less than -16% or greater than +16%.

Investors only can spend compounded returns, not average returns.  This chart presents the difference between average returns and compounded returns for investors.  The two issues assessed are the impact of negative numbers and the impact of volatility, as measured by the variability within a sequence of returns.  Both issues can devastate the actual returns realized by investors compared to the average.  The first issue—negative numbers—is demonstrated by this example: an increase of +20% and a decrease of -20% may average zero, yet the net result is a loss regardless of the order in which they occur. The second dynamic—volatility—is illustrated by another example: the compounded return from three periods of 5% returns is greater than any other sequence that averages 5%.

Even an extended period of 20 years does not ensure positive cumulative returns in the stock market.  Returns appear to be dependant upon the starting level of P/E ratios.  When P/E's are relatively high and above the average, investors' returns over the subsequent 20 years have been below average or negative.  When P/E's are relatively low and below the average, investors' returns have been above average and rewarding.

Despite the general contention that the economy and the stock market are inexorably connected, the facts get in the way of confirming common wisdom.  This chart presents the average stock market return and average GDP growth by decade and by secular bull/bear market cycle.  Economic growth is not the primary driver of stock market returns; stock market returns are driven primarily by a cycle in the P/E ratio (see the Secular Cycles chart above).  Although economic growth does increase the denominator in the P/E (earnings), actual returns are generally the result of trends in the P/E ratio.  This and other research that Crestmont has conducted dispels this conventional notion.

Conventional stock market wisdom has promoted a fundamental relationship between P/E ratios and interest rates.  It relied upon a key assumption that inflation was positive—that deflation was not a possibility.  As reflected in this chart, P/E ratios increase when inflation trends toward price stability (near 1% inflation) and P/E ratios decline when inflation trends away from price stability.  The result is a "Y Curve" effect; where P/E decline into deflation despite low interest rates.  This is consistent with the modern 'dividend discount model' since earnings and dividends would be expected to decline during deflation and therefore would result in lower valuations.

This analysis presents an uncanny relationship between stock market performance and the volatility of the market.  We do not assert a causal relationship; rather, the coexistence of the relationship implies that many measures of risk actually compound in declining markets.  As well, the reward-to-risk relationship significantly improves in strong markets.  In the context of secular bull and bear markets, this relationship further emphasizes the need to consider risk as well as reward in an investor's investment decisions. 

Participants  in our website have raised numerous times the appearance that the market's gains are limited to a small number of days.  It has raised questions about the value of trying to time the market.  Although it is technically true that a few days provide the full year's return, it is a bit misleading and seems to be a biased use of statistics.  Since almost half of the days or weeks are positive (and thus half or so are negative), the majority offset each other.  The result is that a few good days or few bad days 'make' the year.  Of course, this completely ignores the fact that certain periods have favorable financial potential (secular bull markets) and certain periods have unfavorable financial potential (secular bear markets).  The same logic that encourages investors to stay in the market seeking gains also subject them to the adversity of down markets.

"Row, Not Sail."  In strong trending markets, like secular bull markets, the best strategy is to get fully invested and remain so.  Let the profits and over allocation in equities compound to your benefit.  In choppy and volatile markets, a more frequent rebalancing approach can add significant additional return to an investor's portfolio.  Based upon recent secular market history, the risk (cost) of more frequent rebalancing in secular bull markets is far less than the opportunity from more frequent rebalancing in secular bear markets.  Rebalancing is the active management technique that capitalizes on market cycles. Over-performance in one category (asset class) is shifted to another category to benefit from the second category's later good performance.

Up today and down tomorrow.  The stock market seems to be constantly reacting to good news and bad news....sometimes "because of" the news and other times "despite" the news.  In this research, we explore the portion of days that the market is up compared to the number of days it is down.  Over the past five decades, through secular cycles, decades, and individual years, the range of up-days versus down-days is relatively close to 50%.  However, a few extra up-days generally make for a positive period.  Interestingly, as the second page will show, the average net day (average up day offset by average down day) declines during positive return periods.

Four reasonable inflation scenarios, a pragmatic analysis, and the standard Dividend Discount Model explain why there is a natural (rational) limit to Price/Earnings ratios in the stock market. These scenarios reinforce the empirical evidence graphically presented in the "Y Curve Effect."  Inflation leads its way through the credit markets into expected stock market returns.  As well, inflation determines nominal growth in the economy, which in turn drives future earnings growth. The combination provides the essential variables to predict P/E ratios using the Dividend Discount Model.  This analysis is complemented by "Financial Physics" and "The Yield Curve, The Fed, & P/Es"

Shiller's shortfall is its strength. The shortfall relates to the results for 2003 from using the stock market index methodology employed by Professor Robert J. Shiller (Yale University; Irrational Exuberance) and many other sophisticated experts. The "index value" of the S&P 500 for each year is based upon the average daily index throughout the entire year rather than using only one point at year-end. The average of each day across the year better reflects the market level and change than a single point and is used by many financial market analysts. The strength of the methodology is that it mitigates the "single-point risks" of using one arbitrary value for each year (i.e. year-end); the average of all days across the year better reflects stock market's level for that year. Although the annual return for the average index varies from the return using year-end indexes, the results over multi-year periods will be more accurate and valid by using the average index. As a result of the market movements and timing over the past two years, the average index reflects a decline for 2003 rather than the gains that occurred in the year-end values. Even though the index increased by +26% from December 2002 to December 2003, the average index for 2003 was -6% lower than 2002. The good news is that the lackluster 2004 will likely reflect a solid gain over 2003.

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In April 2005, "A Minsky Review" explored the risks and implications of low volatility in the markets. That analysis predicted an increase in market volatility by the end of 2006. One year later, April 2006, volatility has plunged further and is now in the lowest five percent of all periods since 1950. With numerous new and updated charts and graphs, this article explains that "the tectonic plates of the markets are intensely balanced in an edgy state of latent eruption." Beyond presenting an assessment of current conditions, this analysis discusses the timing and implications of a reversal to rising volatility based upon the lessons of history.

In 1972, P/Es were almost 18, the market was approaching and exceeding new highs, volatility was low, and the market was in the first half of a secular bear market…what happened next is now history--if it happens again, it won’t surprise the old sages... This presentation is a self-explanatory look at the last secular bear market cycle and a similarly optimistic period during the first half of that cycle.

The long-term view of the stock market reflects extended periods of surge and stall.  These periods, known as secular bull markets and secular bear markets are not optical illusions; rather they are extended periods when market valuations (i.e. price/earnings ratios: P/Es) are either multiplying the effect of rising earnings or mitigating them. Secular bull market periods have always started when P/Es were below average, and secular bear markets have never ended when P/Es were above average.

ADDENDUM

ADDED

"About Every

 Five Years..."

There has been no greater factor to the variability of investors' returns over decade-long periods than the impact of the trend in the market P/E ratio.  History shows that the change in the market P/E ratio over a decade often doubles or halves investor returns.  This article and its graphs explain P/E, explore its history, and detail its implications.  An addendum titled "About Every Five Years..." has been added to discuss periodic distortions in the P/E ratio (including the significant distortion in 2006 and 2007).

(revised with

recent data;

EPS graphs

update)

Earnings have increased at double-digit growth rates for five consecutive years—it’s beyond almost everyone’s foreseeable horizon that earnings might soon experience a decline. Despite the statistics about average earnings growth, the business cycle drives periods of surge and stall. This analysis explores the earnings growth cycle, the profit margin cycle, and then translates the outlook into specific implications for returns over the next decade. As an analogy, winter is not a time for farmers to hibernate; rather it’s a period to approach crops differently. Today’s investors have so many tools and techniques available to them to actively “row” and invest like institutions, thereby seeking relatively consistent returns with a lot less disappointment risk.

final 2006 results)

Why are so many of the most knowledgeable institutions and individuals shifting away from investment portfolios that have been concen-trated in stocks and bonds toward a more diversified and risk-managed profile? The tools and resources are now available to permit investors of all sizes to use this enhanced approach and be successful.  This article describes the dynamics and benefits of seeking more consistent, absolute returns rather than investing simply for the relative returns of the stock market.  Since it relates to the stock market and since it uses hedge fund indexes as a proxy to illustrate absolute returns, it is posted in both the Stock Market and Hedge Funds sections.

There has never been a thirty-year period for the stock market when investors have lost money; yet there have quite a few thirty-year periods that have bankrupted senior citizens who were relying upon their stock portfolios for retirement income. Although history provides an average outcome across a wide variety of market conditions, it is only relevant today to consider periods with characteristics similar to today. Given the significant impact of valuation on returns, that factor will be a major driver for today’s investors and retirees.

The reality is that the business cycle is different than the economic cycle--GDP growth is much more consistent than EPS growth.  It may surprise some to know that EPS declines can occur during periods of economic growth.  Across the 57 years since 1950, earnings declined during 19 of them despite positive economic growth in all of those years...33%!  Real GDP growth (excluding inflation) has lagged the historical 3% average thus far in the 2000s.  To get to average, it will require above average growth for the next three years.  But even if the economy looks solid for the next few years, history highlights that EPS is not immune to decline--especially from such a currently high level of profit margins.

A simple analysis--a powerful statement. What percent of the gains during positive months is needed to get stock market returns if an investor avoids the declines? Many "rowing" strategies, including hedge funds, are criticized for not getting much return during market declines and then not being able to beat the stock market on the upside.  The answer: if an investor can avoid the losses, it takes only 30% of the positive gains to match the market.  And, if losses are contained to 50% of the market drop, it takes only 64% of the gains to achieve market returns. So the main objective of "rowing" is to avoid the losses...and the gains will seem to take care of themselves.

The simple analysis--graphed.  Many "rowing" strategies are criticized for not getting returns during market declines and then not being able to beat the stock market on the upside.  The answer: if an investor can avoid the losses, it takes only a fraction of the positive gains to match (or beat!) the market.  So the main objective of "rowing" is to avoid the losses...and the gains will seem to take care of themselves.

The starting valuation matters!  When P/Es start at relatively lower levels, higher returns follow--paying less yields more. When investors have P/Es that start higher, subsequent returns are lower. This graphical analysis presets the compounded returns that follow over the subsequent ten years based upon the starting P/E ratio.  It's compelling, primarily because it's fundamental--starting valuations directly impact subsequent returns.  From the current above-average valuations, below-average returns are likely to follow for the next decade or longer.

Who or what is rocking the boat? Market volatility has recently surged; investors have had to hold on and try to figure out what this means. Is the current level of volatility “normal” or is it extreme? The purpose of this presentation is to graphically put volatility into historical perspective. This will be updated every other month or so until volatility again falls to levels of investor disinterest…which could be a while if history is a guide for what can be expected.

Earnings had been increasing at double-digit growth rates for five consecutive years from 2002 through 2006—although many agreed that earnings growth might be slowing, it was beyond almost everyone’s foreseeable horizon that earnings might actually experience a decline. Yet, before anyone knew it, the end of the cycle was in the rear-view mirror rather than beyond the distant horizon. This article is a follow-up to “Beyond The Horizon: The EPS Cycle” (located above).  Has the forward P/E, which was recently an inviting 16, suddenly become a much richer valuation near 20?