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Read this and you’ll be better equipped to forecast than 99% of the population.
The Two Things That Drive Stock Price
There are only two things that drive a company’s stock price.
Ultimate Earnings: The first is ultimate earnings or profit potential. Notice that I did not say current earnings and profit, but rather ultimate earnings or profit potential. Sometimes investors use a proxy such as revenue to value a company in its current state, but the proxy is almost always meant to assess the ultimate profit potential they can sell to a future buyer. To better understand this, I’ve written a companion article that walks through various strategies and metrics you have probably heard about and shows how they ultimately tie to earnings. Read that and meet me back here to proceed.
Earnings Multiple: The second driver is the multiple assigned to those potential earnings. The relative ranking is always preserved; you will almost always pay a higher multiple for an equivalent company growing fast vs one that is stagnant, for example. However, how big the gap is in multiples between different investment opportunities can change over time. And what multiple you assign to a software company vs an agriculture company can change over time. What multiple you assign to a profit stream from equities vs bonds can change over time. The multiple is the second factor that drives stock price.
US Stock Market Outlook: 2017 and The Next Decade
When you hear people talk about potential challenges in the US stock market going forward, you can use the two drivers above to break down their explanations.
Concerns about Brexit impacting trade, the ambiguity of economic policies due to the change in hands of the Presidency, and other factors that may have an impact on how much revenue US companies generate. This ultimately affects how much flows to earnings and thus fall into the first driver’s bucket.
Then there is a second piece, which is how those profit streams will be valued. How are other asset classes like bonds looking compared to investing in stocks? How is investment into other countries stock markets looking compared to US investment? Basically, where do US equities stack rank amongst all opportunities to deploy capital and thus how high a multiple should we assign to those earnings?
This is, in my opinion, where the bulk of the volatility will come from in 2017 and years that follow (note, these kinds of discussions only work in a 10+ year time frame). Notice as you look at this chart how high today’s price to earnings multiples are in comparison to the median.
Ultimately, the question you must ask yourself is why did people pay on average 14.65 times earnings over the course of 130+ years but are paying 25.4 times now? Is it for a sustainable reason or a sign of a bubble?
My personal view of where the stock market will go in the next few years is that it will underperform historical compound annual growth rate (CAGR) figures by one to two points, coming in at around a 7% CAGR return.
How do I get there?
The historical CAGR of earnings over the past 30 years is about 6.1% (source here). On top of that, the current dividend rate is about 2%. I see no reason in my modest growth scenario for dividends to either significantly increase or significantly decrease. So that’s a roughly 8.1% return.
Now we return to the earnings multiple. 25.4 times is historically very high. Given the recent hikes in the interest rate, buying bonds and clipping a higher and higher coupon will become a more attractive option over the years. In addition, the safety and certainty of bonds may be tempting to investors in an uncertain political environment. These two things are just a few examples of what might cause the earnings multiple to fall for stocks: investors can deploy their money in assets that are increasingly more attractive, eventually defecting and driving the going multiple down. Having the multiple fall to 20 times earnings, a drop of 20%, would still put it above the median and relatively high compared to history.
So I take my 6.1% earnings growth expectation and I multiply it against a 20% lower multiple than the current multiple. That means I’m getting 4.9% return based on earnings growth, plus a 2% dividend for a total return of 6.9%.
Based on historical data and my current view of economic indicators, I believe the stock market will underperform its historical performance by 1 to 2 pts and deliver an average 7% CAGR return in 2017 and the next decade.
Of course, the purpose of all this is not for you to take my prediction as gospel, but to have built a framework for you to make your own prediction. Perhaps you don’t agree with what economic indicators say about earnings growth and you want to forecast higher earnings growth than last year. Or maybe you do believe there are fundamental reasons for the price to earnings ratio to be as high as it is compared to history and so you don’t expect to see it dip. Whatever your personal research tells you, you now have the tools to determine where you think the market will go in 2017 and beyond.
Interested in more? This is the first in a three-part miniseries. Coming up will be a post on bond price changes as well as a post on how to allocate your portfolio between stocks and bonds.
If you don’t have a system already, make sure you set up a way to track your investment portfolio mix to get the most out of these articles. The method I’ve used to track my portfolio the last two years, which is free, can be found here.