John Mauldin over at the Ritholtz’s Big Picture writes about long-term investing, what it means (He defines as a 20 year horizon), and when it works (He also discusses how Europe is in big, big trouble, but that is another topic that is being widely discussed).
As part of this long-term investing discussion, he takes to task some of the bromides bantered about regarding missing bull markets, “no pain no gain,” blah blah buy! buy! buy! etc.
It’s a long read for a blog post, but there is some worthwhile nuggets. What I really took away was here:
In the 103 years from 1900 through 2002, the annual change for the Dow Jones Industrial Average reflects a simple average gain of 7.2% per year. During that time, 63% of the years reflect positive returns, and 37% were negative. Only five of the years ended with changes between +5% and +10% – that’s less than 5% of the time. Most of the years were far from average – many were sufficiently dramatic to drive an investor’s pulse into lethal territory!
Almost 70% of the years were “double-digit years,” when the stock market either rose or fell by more than 10%. To move out of “most” territory, the threshold increases to 16% – half of the past 103 years end with the stock market index either up or down more than 16%!
Read those last two paragraphs again. The simple fact is that the stock market rarely gives you an average year. The wild ride makes for those emotional investment experiences which are a primary cause of investment pain.
The stock market can be a very risky place to invest. The returns are highly erratic; the gains and losses are often inconsistent and unpredictable. The emotional responses to stock market volatility mean that most investors do not achieve the average stock market gains, as numerous studies clearly illustrate.
Not understanding how to manage the risk of the stock market, or even what the risks actually are, investors too often buy high and sell low, based upon raw emotion. They read the words in the account-opening forms that say the stock market presents significant opportunities for losses, and that the magnitude of the losses can be quite significant. But they focus on the research that says, “Over the long run, history has overcome interim setbacks and has delivered an average return of 10% including dividends” (or whatever the number du jour is. and ignoring bad stuff like inflation, taxes, and transaction costs).
The 20-Year Horizon
But how long is the “long run”? Investors have been bombarded for years with the nostrum that one should invest for the “long run.” This has indoctrinated investors into thinking they could ignore the realities of stock market investing because of the “certain” expectation of
This faulty line of reasoning has spawned a number of pithy principles, including: “No pain, no gain,” “You can’t participate in the profits if you are not in the game,” and my personal favorite, “It’s not a loss until you take it.”
These and other platitudes are often brought up as reasons to leave your money with the current management which has just incurred large losses. Cynically restated: why worry about the swings in your life savings from year to year if you’re supposed to be rewarded in the “long run”? But what if history does not repeat itself, or if you don’t live long enough for the long run to occur?
For many, the “long run” is about 20 years. We work hard to accumulate assets during the formative years of our careers, yet the accumulation for the large majority of us seems to become meaningful somewhere after midlife. We seek to have a confident and comfortable nest egg in time for retirement. For many, this will represent roughly a 20-year period.
We can divide the 20th century into 88 twenty-year periods. Though most periods generated positive returns before dividends and transaction costs, half produced compounded returns of less than 4%. Less than 10% generated gains of more than 10%. The P/E ratio is the measure of valuation reflected in the relationship between the price paid per share and the earnings per share (“EPS”). The table below reflects that higher returns are associated with periods during which the P/E ratio increased, and lower or negative returns resulted from periods when the P/E declined.
Look at the table above. There were only nine periods from 1900-2002 when 20-year returns were above 9.6%, and this chart shows all nine. What you will notice is that eight out of the nine times were associated with the stock market bubble of the late 1990s, and during all eight periods there was a doubling, tripling, or even quadrupling of P/E ratios. Prior to the bubble, there was no 20-year period which delivered 10% annual returns.
Why is that important? If the P/E ratio doubles, then you are paying twice as much for the same level of earnings. The difference in price is simply the perception that a given level of earnings is more valuable today than it was 10 years ago. The main driver of the last stock market bubble, and every bull market, is an increase in the P/E ratio. Not earnings growth. Not anything fundamental. Just a willingness on the part of investors to pay more for a given level of earnings.
Every period of above-9.6% market returns started with low P/E ratios. EVERY ONE. And while not a consistent line, you will note that as 20-year returns increase, there is a general decline in the initial P/E ratios. If we wanted to do some in-depth analysis, we could begin to explain the variation from this trend quite readily. For instance, the period beginning in 1983 had the lowest initial P/E, but was also
associated with a two-year-old secular bear, which was beginning to lower 20-year return levels.
Look at the following table from my friend Ed Easterlin’s web site at www.crestmontresearch.com
(which is a wealth of statistical data like this!). You can find many 20-year periods where returns were less than 2-3%. And if you take into account inflation, you can find many 20-year periods where returns were negative!
Look at the 20-year average returns in the table above. The higher the P/E ratio, the lower (in general) the subsequent 20-year average return. Where are we today? As I have made clear in my last two letters, we are well above 20. Today we are over 30, on our way to 45. In a nod to bulls, I agree you should look back over a number of years to average earnings and take out the highs and lows of a cycle. However, even “normalizing” earnings to an average over multiple years, we are still well above the long-term P/E average. Further, earnings as a percentage of GDP went to highs well above what one would expect from growth, which is usually GDP plus inflation. Earnings, as I have documented in earlier letters, revert to the mean. Next week, I will expand on that thought.
And given my thesis that we are in for a deep recession and a multi-year Muddle Through Recovery, it is unlikely that corporate earnings are going to rebound robustly. This would suggest that earnings over the next 20 years could be constrained (to say the least).
In all cases, throughout the years, the level of returns correlates very highly to the trend in the market’s price/earnings (P/E) ratio.
This may be the single most important investment insight you can have from today’s letter. When P/E ratios were rising, the saying that “a rising tide lifts all boats” has been historically true. When they were dropping, stock market investing was tricky. Index investing is an experiment in futility.
You can see the returns for any given period of time by going to http://www.crestmontresearch.com/content/Matrix%20Options.htm.
Now let’s visit a very basic concept that I discussed at length in Bull’s Eye Investing. Very simply, stock markets go from periods of high valuations to low valuations and back to high. As we will see from the graphs below, these periods have lasted an average of 17 years. And we have not witnessed a period where the stock market started at high valuations, went halfway down, and then went back up. So far, there has always been a bottom with low valuations.
My contention is that we should not look at price, but at valuations. That is the true measure of the probability of success if we are talking long-term investing.
Now, let me make a few people upset. When someone comes to you and starts showing you charts that tell you to invest for the long run, look at their assumptions. Usually they are simplistic. And misleading. I agree that if the long run for you is 70 years, you can afford to ride out the ups and downs. But for those of us in the Baby Boomer world, the long term may be buying green bananas.
If you start in a period of high valuations, you are NOT going to get 8-9-10% a year for the next 30 years; I don’t care what their “scientific studies” say. And yet there are salespeople (I will not grace them with the title of investment advisors) who suggest that if you buy their product and hold for the long term you will get your 10%, regardless of valuations. Again, go to the Crestmont web site, mentioned above. Spend some time really studying it. And then decide what your long-term horizon is.