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ADec 31, 2012

Why We’re Headed For Decent Market Returns Ahead

Andrew Hallam

On January 14, 2000 the Dow hit 11,722 points.  As I write, it’s at 13,190 points…just 12.5 percent higher.  Before concluding the relative failure of American businesses over the past dozen years, you may consider a different measuring stick:  business earnings growth.  Valueline provides free historical earnings data for the Dow Jones Industrial stocks.  You might be surprised to hear that the past eleven years have seen fabulous growth.

Since 2001, as measured by earnings per share, 3M Company has improved by 250 percent; Caterpillar increased 697 percent; Chevron’s profits rose 690 percent, and JP Morgan Chase’s earnings per share are up 887 percent.  I averaged the EPS growth for all 30 Dow stocks between 2001 and 2012.  For good measure, I also included five other companies that have been demoted from the Dow composite:  Citigroup, Eastman Kodak, Kraft Foods, General Motors and Goodyear Tire and Rubber.

Earnings per share growth since 2001, including the five demoted businesses, averaged 186 percent or 10.02 percent per year.  You may be wondering why the stock market performed so poorly in light of such growth.

One reason overshadows all others:  twelve years ago, the market was much higher than it deserved to be.  Business earnings hadn’t risen enough to warrant the silly price to earnings ratios we were seeing.  Stocks move in correlation with earnings.  They always have, and they always will.  But we often forget that.  The 100 year average PE ratio for Dow stocks has been 14X earnings.  Twelve years ago, the Dow traded at twice that level. 

In my book, Millionaire Teacher, I equated the stock market to a dog on a long leash.  In my analogy, the dog’s owner represented business earnings.  No matter how quickly that dog (the market) moves ahead of its owner’s pace (business earnings) it can’t break free.  If the dog races ahead, it eventually has to slow down.  If the dog lags, it must sprint to catch up.  Being disappointed by the stock market over the past dozen years isn’t rational, unless we expected something unprecedented to happen.  “This time it’s different” are the four most costly words an investor can utter.

From 1920-1929 U.S. business earnings (as measured by the Dow) increased 118 percent, while the DOW stocks gained 271 percent, not including dividends.  Ten years later (in 1939) the market was still nearly 41 percent lower than it was in 1929.  The racing dog had choked on its collar and had to come back.

From 1955-1965 business earnings grew 50 percent.  The market grew nearly 100 percent.  Ten years later, the market was 9.3 percent lower.  Again, the dog was pulled back by the owner.

From 1990-2000 earnings increased 152 percent while the market gained 290 percent.  Ten years later?  You already know the story.

When stock prices dramatically outpace business earnings, as they did during the 1990s, investors always, eventually, pay the price.  A couple of hundred years of stock market history spell out the same reality.

The good news is this.  Today, the U.S. market’s PE ratio is at 14X earnings, roughly the 100 year average.  The dog is trotting alongside the owner.  Over the next ten years, if the Dow businesses grow at half the rate they grew during the previous eleven years, we could see some reasonable stock market returns. 

If they increase their earnings by just 5 percent each year, and if the average stock trades at 14X earnings, this composite index, including a 2.5 percent dividend, would see investors average 7.5 percent annually between now and 2023. 

American businesses have done well during the past eleven years.  If they do half as well, going forward, you’ll probably earn some decent stock market profits. 

Currently, such optimism about the market is hard to find.  That’s a good thing.  Bull markets never begin when there’s a rosy economic consensus.  They break free during the darkest hours instead. 

Filed Under: Investing