Allan Sleeman: “EIGHTEEN LEAN YEARS? Just got around to reading the column where you allude to this. Did I miss something — Oh God, another Senior Moment! — or have you just joined the reversion-to-the-mean crowd (non-entities like Warren Buffet and John Bogle)? I would have thought, naive person that I am, that this would have been a major insight to share with us poor peons. But maybe you did do a piece on the expected long-term behavior of the market. If not, I at least would be extremely interested to learn why you are talking about much lower expected returns. Then, of course, I would like to know what sort of advice you would give about what to do about this, particularly to those of us who are planning to retire soon (‘don’t’ may be good advice but it is so depressing!). Naturally I am aware that a number of smart people have written whole books on the subject recently, but please boil it all down into a couple of paragraphs.”

1. “I would be interested to learn why you are talking about much lower expected returns”

Because price/earnings ratios have been expanding for 18 years and interest rates generally falling. This cannot go on forever, and even if it just stopped, let alone reversed, returns would be lower than they have been.

Right? If people are willing to pay $12, say, for each $1 of corporate earnings — 12 times earnings — and if those earnings are rising at 9% a year, stock prices will also rise at 9% a year. But if as the earnings are growing the multiple people are willing to pay is also grow, say to 30 times earnings, stock prices will have grown at a much faster than 9% rate. But now, say, the expansion in multiples stops and they stay steady at 30 times earnings. With 9% earnings growth, you are back to a world where stocks also grow at 9% a year. Unless the multiple people are willing to pay should actually begin sliding back down again. Then, even with 9% earnings growth, stock prices could actually fall for a while, or at least rise less quickly. And what if corporate earnings didn’t grow 9%, but only 5%? Or actually slip for a while?

I don’t know where earnings are going — up, I imagine, in most years. But I do doubt that the stock market multiple will rise much further, and would not be surprised to see it contract. So the big fun — 18 years of rising multiples — would seem to me to be over.

Obviously, there will be ups and downs in all of this. Obviously, “the market” is many markets combined into one. Lots of stocks have never come close to being richly valued, while others have been bid to crazy heights. Obviously, some of the adjustment to more moderate returns has already occurred. (The NASDAQ is down about 20% from its high, the Dow off nearly 10% . . . even as earnings have been growing . . . so some of the moderation in multiples has already occurred.)

There are some fantastic forces that bode well for the future, and could argue against “reversion to the mean.” (Reversion to the mean is the notion that when things have been rising above average for a long time, they will eventually rise below average for a while until, overall, the traditional average is restored. It’s a law when it comes to flipping coins, but only a strong suspicion when it comes to the stock market. “Mean,” meanwhile, for those of you who were doodling that day, is the same as “average.” Median is the one that’s different. [If you have 10 people earning $20,000 a year and one earning $20 million, their median income will be $20,000 — the mid-point person’s pay — but their average/mean income will be $1.84 million.])

What are these fantastically positive forces?

  • The peace dividend, which allows the world to spend less on nonproductive things (like hiring young people to leave assembly lines making things and employ them, instead, killing other young people or blowing up factories). The U.S. used to spend 6% of its GNP on defense, now closer to 2% — a huge swing. Russia used to spend 25% and must be spending less now. I don’t have global numbers, but they are a lot lower than in decades past.
  • Freer trade and ever broader acceptance of free-market economics. Remember Ec 1 and the laws of comparative advantage? No? Well, free trade enriches all its participants over the long run — both Mexico and the US are better off because of NAFTA — even though it can cause short-term pain to specific people (if, say, it cost you your job) or companies (if, say, it put yours out of business). Same with free-market economics. Free market economies are more prosperous than controlled economies. (That said, enlightened regulation is absolutely necessary to make these things work. The anti-trust mechanism is indispensable to a successful marketplace, as are the Securities and Exchange Commission, the Federal Reserve, the Federal Trade Commission, and on and on. In trade, we need to be leaning on our trading partners, gently but persistently, to lift their workplace and environmental standards, as we have lifted our own.)
  • Technology. It’s beyond magic, what’s going on these days, and should be reflected in greater productivity and prosperity.

These three argue for raising “the mean.” Maybe the average performance of the stock market — traditionally about 9% a year when you combined dividends a price appreciation (and before you adjusted downward for inflation) — should be permanently higher.

But I doubt it. Or at least not dramatically. Even a 1% increase, in the first place, is dramatic. A dollar growing at 9% becomes $5,529 after 100 years — but $13,780 growing at 10%. So it would be a huge thing, really, for “the mean” to have risen from 9% to 10%.

And maybe it has.

But it sure hasn’t risen to 15% or 30% or any of the crazy numbers some people have come to expect from the stock market.

And for all the power of peace, free trade and, especially, technology, there is a flip side. Can we be sure the world will always be so relatively peaceful? What would a little cyber-terrorism do to e-commerce and productivity and consumer confidence and corporate earnings? Not to mention potential military conflicts and arms races sometime in the future. And little issues like global warming — and inflation.

Technology is dazzling. But, as has been often noted, things like “electricity” were not trivial themselves. Radio and television were pretty big deals, too. Yet even with those astonishing economic shots in the arm, the stock market used to provide about a 9% annual return.

So, yes, I think large segments of the market have probably gotten ahead of themselves, and that even after the substantial correction earlier this year, which has helped to right the risk/reward ratio somewhat, people should be prepared for a less spectacular 18 years in the U.S. stock market going forward than the 18 we have just enjoyed.

2. “Then, of course, I would like to know what sort of advice you would give about what to do about this, particularly to those of us who are planning to retire soon . . . ”

My advice is: Come back tomorrow.


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