Booming stock market doesn’t mean you can save less

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.