Boom­ing stock mar­ket doesn’t mean you can save less

The Denver Post - - BUSINESS - Char­lie Far­rell is chief ex­ec­u­tive of North­star In­vest­ment Ad­vi­sors LLC. He is the au­thor of “Your Money Ra­tios: 8 Sim­ple Tools for Fi­nan­cial Se­cu­rity.” This col­umn is for in­for­ma­tion and ed­u­ca­tion pur­poses only.

Over the last sev­eral years, the stock mar­ket has marched for­ward as if it doesn’t have a care in the world. While it’s al­ways nice to see your 401(k) bal­ance grow, it’s good to re­mem­ber that stock mar­ket gains need to be sup­ported by cor­po­rate prof­its, and lately we’ve had a dis­con­nect be­tween mar­ket re­turns and ac­tual cor­po­rate earn­ings.

Why should in­vestors care? The more stock prices rise without a sim­i­lar in­crease in cor­po­rate prof­its, the higher the odds are of a sig­nif­i­cant mar­ket cor­rec­tion or a long pe­riod of stag­nat­ing re­turns. While the stock mar­ket can seem like a mys­te­ri­ous beast that swings around ran­domly, the re­al­ity is that long-term stock mar­ket re­turns are closely tied to cor­po­rate prof­its. Let’s go back 20 years and take a look at this link.

Over the last 20 years, prof­its for com­pa­nies in the S&P 500 in­dex (a good mea­sure of the U.S. stock mar­ket) grew at about 4.9 per­cent per year and the price of the S&P 500 in­dex grew at about 5.2 per­cent per year. You can see there is a tight cor­re­la­tion over the long-term be­tween these two num­bers. And the fur­ther back in time you go, the more con­sis­tent this re­la­tion­ship is be­tween prof­its and prices. What you’ll also no­tice from study­ing the his­tory of cor­po­rate earn­ings is that prof­its are not that volatile from year to year.

So if cor­po­rate prof­its aren’t that volatile and stock prices are sup­posed to re­flect cor­po­rate prof­its, why is the stock mar­ket so volatile? It’s be­cause in­vestors are ir­ra­tional. No one knows why, but they are. The ba­sic prob­lem is in­vestors tend to over­pay for stocks when times are good, and then when stocks don’t live up to the lofty ex­pec­ta­tions, in­vestors flee. When in­vestors leave, stocks ei­ther crash or en­ter long pe­ri­ods of stag­na­tion. This re­trench­ment even­tu­ally re­aligns stock prices with stock prof­its.

Let’s look at the cur­rent sit­u­a­tion for prof­its and prices in the S&P 500 and see where we are in this cy­cle. Back in Septem­ber 2014, the prof­its for all the com­pa­nies in the S&P 500 in­dex were about $106 per share. We are in the midst of sec­ond quar­ter earn­ings re­ports for 2017, and the es­ti­mate is that S&P 500 prof­its will come in at about … $105 per share. Thus, prof­its haven’t grown at all in al­most three years. Yet, the price of the S&P 500 in­dex is up about 23 per­cent over that same time pe­riod.

One good mea­sure of stock mar­ket val­u­a­tion is the price-toearn­ings ra­tio. Back in Septem­ber 2014, it was about 18.5, and today it’s over 23. This is an­other way of say­ing we are sim­ply pay­ing more for the same amount of prof­its. The long term av­er­age PE ra­tio is about 16, and mar­kets tend to re­vert to that av­er­age at some point.

As you can see from a cou­ple of dif­fer­ent per­spec­tives, we are cur­rently in the “op­ti­mism” phase of the mar­ket where prices are out­pac­ing prof­its. What this means is that we are more likely to see a fu­ture pe­riod of sub-par price re­turns, which will serve to re­align prices and prof­its. Thus, you don’t want to project for­ward the re­turns you’ve seen over the last few years. They are some­what un­re­al­is­tic.

From a prac­ti­cal stand­point, how does this im­pact your re­tire­ment plan­ning? Well, if we are likely to see a fu­ture pe­riod of lower re­turns, it means you’ll have to save more. How much more? If mar­ket re­turns over the next 20 years are closer to 7 per­cent, com­pared to the 10 per­cent peo­ple have been get­ting re­cently, you’ll need to save al­most 70 per­cent more money to get to the same place (mean­ing if some­one was sav­ing 5 per­cent of pay, they’d have to save closer to 8.5 per­cent).

Yet as mar­kets post big pric­ing gains, the ten­dency is to save less be­cause it looks like the mar­ket will do most of the heavy lift­ing for you. The odds are they won’t. There are many rea­sons why growth going for­ward is likely to be mod­est. Is­sues like the global de­mo­graphic costs of ag­ing, high debt lev­els, fall­ing la­bor par­tic­i­pa­tion, lower pro­duc­tiv­ity and then high val­u­a­tions all stack up to re­duce the odds of big re­turns in global stock mar­kets. Re­mem­ber, prices will track those prof­its, and for the last 20 years they have been mod­est, and the hur­dles have only got­ten big­ger.

This doesn’t mean you can’t do well by in­vest­ing. It just means you have to be re­al­is­tic, and the main way to com­bat lower re­turns is through higher sav­ings. Do what you can to raise your sav­ings rate, it’s one of the few things in fi­nance that you can con­trol.

Newspapers in English

Newspapers from USA

© PressReader. All rights reserved.