Average Ain’t Average

Oh boy, oh boy.  A little knowledge can go a long way and we have some facts that you will find titillating (perhaps not, but at the least, very useful).

Last month we did a review of bonds (who issues them, how they work, some of their unique challenges, etc.).  This time, let’s take an explanative stroll down the stock lane, but do it differently than how it’s normally explained.

Different than bonds, stocks don’t owe you anything.  A stock gives you a share of ownership of the company.  That’s why they call them shares (and before the days of computers the company name would be written on the chalk board at the Exchange to show that the shares of that company were part of the “list” that could be traded, thus the company became ‘listed’, but we digress).  These shares don’t have to literally pay you anything after you buy them, but instead represent a ‘terminal value of the company’.  That means you get a piece of the forklift in the factory, or the inventory in Brazil, should it close up business TODAY.  However, what it mostly means is that through this share ownership you are entitled to a piece of the future earnings of this company.  If the money earned is not paid out to shareholders in dividends each year, and it stays in the company, it gets included in an account known as the company’s ‘retained earnings’.

Experts generally agree that a stock has MORE of its value based upon expected future profits than it does in the value of that forklift or inventory.  It’s easy to count that stuff yet, let’s be honest, it’s harder to make a buck.  There are those picky customers and nasty competitors that make it challenging to have people voluntarily elect to spend their hard earned money with you…but if you really do deliver good products and services, they will happily and possibly repeatedly move money from their wallet to your corporate bank account.

Now, the hard part is figuring out how much money that one company is going to make in the future.  That’s why individual share prices go up and down like the old yo-yo’s used to do.  Everybody’s got an opinion.  But the collective opinion is what sets the price that a share sells for on stock exchanges (where one guys exchanges his share for money to someone else).  However, two astounding facts for your next wine and cheese party to make you look like a genius (and yes, we am quite sure, your mother already knew that);

  1. Certain ‘experts’ think that the value of a share is emotionally driven, and that profits matter little.  I assert that can’t be true.  In the year 1935, the S&P 500 closed out at 13.  As of this last Friday it closed at 2,423.  That’s 186 times higher, and why is the index up this amount?  Because that’s almost exactly how much earnings have risen.  In fact, according to Bloomberg, the correlation between earnings and stock prices since 1935 has been 0.95[i], which even to an accountant sounds as statistically as perfect as you can get!
  2. If you think that is something, grab onto this next one Sherlock.  Though the S&P index has gone up about 10.0% per year, that doesn’t mean stocks gained 10% every year.  In fact, since 1926, the S&P index has NEVER been up 10%.  Very remarkably, stocks have gained between 9% and 11% per annum only twice over the entire past 90 years[ii]!  You want average?  We ain’t got no stink’in average!!

Thus, we learn you must be in it to win it, and yet not take too much risk while we’re at it.  You are, and you’re not, respectively.

[i] “2016: The Pouting Pundits Of Pessimism Punished…Yet Again” (Nick Murray Interactive, January 2017)

[ii] Standard and Poor’s Index of Annual and Cumulative Returns (2017 Matrix Book, Dimensional Fund Advisors)