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Causes of Stock Market Returns (Long-Term vs. Short-Term)

I’m currently reading John Bogle’s Common Sense on Mutual Funds. (It’s from 1999, so some of it’s a bit dated, but all the main concepts still hold true.) One point he makes repeatedly in the book is that stock market returns consist of 3 factors:

  1. Earnings growth of the companies owned in your portfolio,
  2. Dividend yield of those same companies, and
  3. Price swings due to changes in investor sentiment.

In the long-run

Bogle points out that in the long-run, the first two factors are the primary cause of returns, as–over time–the price swings will tend to cancel themselves out. He backs this up with data showing that from 1927 to 1997, the market earned a return of 10.5%. It turns out that 8.7% of that return was due to earnings growth and dividend yield, while only the remaining 1.8% was due to market swings. (And I’d bet that once we include the most recent 10 years, which have included 2 major downward corrections, this number would be even smaller than 1.8%.)

In the short-run

Over the short-run, however, the third factor absolutely dominates the other two. For instance, it’s fairly common that, in a given year, earnings growth and dividend yield will both be positive, while the stock market still earns a negative return due to selling-sprees inspired by losses in investor confidence.

Applying this to what we’re seeing today

Just take a look at what’s going on today. As of yesterday, the market was down nearly 40% for the year so far. At the same time, our real GDP (inflation-adjusted Gross Domestic Product) for Quarter 3 of 2008 was only down one tenth of one percent from Quarter 2. From this we can reasonably conclude that the market’s current plummet is primarily caused not by fundamental economic changes, but by what’s going on in the heads of investors around the world: They’re panicking.

By way of comparison, from 1929 to 1933, our real GDP declined by more than 27%. Now that is an economic slowdown. When the economy is producing less than three quarters of what it was producing four years ago, I can see why people might be reluctant to own businesses (stocks).

I’m sure that our Quarter 4 real GDP is going to be down significantly more than the 0.1% drop from Quarter 3, but I think we can all say with confidence that it’s not going to be down anywhere in the range of 27%, much less the 40% that would correspond to our current market drop.

What to do?

In my opinion (and this should come as no surprise), we’re still at the point where most of what’s going on in the market is just noise. Yes, significant economic events (such as failures of several banks and other companies in the financial industry) have occurred this year. But I still haven’t seen anything that’s sufficient to convince me that the market’s current drop hasn’t been caused primarily by factor #3 from our list above.

As long as I have reason to believe that the businesses of the world will continue to make money, I’m going to keep investing in stocks.

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Comments

  1. Interesting insight into the long and short of Stock Markets.
    However, a total long-term strategy may not be the best thing to do.It is imperative to exit to book profits whenever our price tragets are met and enter again when the oppurtunity strikes.
    However,in case of dividend stocks with strong fundamentals,i think its safe to invest and forget

  2. In his book Jeremy Siegel has found that 97% of total stock market returns in the Us between 1871 and 2003 have come from reinvested dividends. If you want to have the power of compounding on your side, you should pick dividend paying companies and reinvest your distributions.

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