The stock market is predictable. Unfortunately.
Over the long term, the range of stock market returns is more predictable than you think. The outlook for this decade isn't heartening.
Investors work hard to make sense of a stock market that eludes understanding. Some years it rises with good news; other years it falls despite good news. Although stock investors are supposed to make about 10 percent a year, in the 2000s they lost money.
Is the market really so random? Despite its apparent complexity, the market, over the long term, is driven primarily by two factors. Although we can't see into the future, those factors offer a range of market returns that are more predictable than you might think.
The first one is earnings growth. Higher earnings deliver higher dividends and often lead to higher stock prices. But there is a constraint to earnings growth. Over time, earnings do not grow faster than the economy. That makes long-term growth a key contributor to market returns.
The second factor is the inflation rate. Deflation and high inflation are market gremlins. They disrupt the higher values and strong gains that low and stable inflation brings.
These two factors – growth and inflation – create uncertainty. So the prudent investor creates a range of scenarios. Here's what that range looks like for the coming decade:
The best scenario for stock market returns in the 2010s includes above-average economic growth with low inflation. If the economy can surge throughout the decade at a rate of 4 percent a year or so, then corporate earnings should likewise benefit. If inflation remains low despite the looming risks, stock market values will benefit from stable inflation and low interest rates. The result to stock market returns, including dividends, would be a solid 8 percent average annual return.
But what if economic growth is average or below and inflation percolates into the economy? The result is slower profits further eaten away by inflation: a double-whammy for stock prices. Similarly, there are concerns about the possibility of deflation, which also hurts stock prices.
Thus, annualized returns will probably fall somewhere between -8 percent and +8 percent – and, also important, not along a smooth curve. There will be years with great gains and years with painful losses. Over the decade, however, the short-term volatility will meld into a muted outcome.
The reality across the combinations is that this will be a "groundhog" decade for the stock market. Just as Bill Murray woke up to the same thing day after day in the movie "Groundhog Day," so investors are likely to repeat the cumulative results of the 2000s. Although some scenarios result in losses that exceed those of the 2000s, a few scenarios generate modest returns. Unfortunately, it would require highly unlikely assumptions to achieve even historically average returns.
Why does this decade, like the past one, have to be subpar? Because fundamental principles drive stock-market returns over time. The most important one is valuation: the price of a stock in relation to the earnings it generates. When stocks are expensive by historical standards, as they are today, subsequent long-term returns are below average. Conversely, the bull-market period of the 1980s and '90s only took off after stocks became cheap in terms of their price-to-earnings ratios.
Unfortunately, the stock market is not a dream machine. It can't always give us what we want. Early recognition of what it is likely to give us, however, enables investors to take action and find the opportunities that will outperform.
– Ed Easterling, head of Crestmont Research, is author of the new book "Probable Outcomes."