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By Michael Dever and John Uebler

History has taught us, again and again, that when it comes to finance, the unexpected should be expected. No single financial system in recorded history has operated without experiencing a crisis that decimated value. It has never been a question of "if," just a question of "when."

The purpose of this article is not to make predictions of economic collapse. It is to ensure that your portfolio is positioned to profit regardless of the economic environment or the performance of any individual market.

Conventional investment wisdom is based on the following assumptions:

  • A portfolio diversified across a number of stocks will provide inherent return over time.
  • It is virtuous and pragmatic to buy-and-hold stocks for the long-run.
  • If you buy stocks for the long run, they will provide you with an intrinsic return.
  • The longer your investment horizon, the lower your investment risk.
  • Short-term stock market returns generally tend to be random.

This conventional wisdom is flawed because it is dependent on a single set of Return Drivers. There is no guarantee that the future won't deviate substantially from the past. In fact, it's a certainty that it will.

In 1900 there were 36 countries with active stock markets. Half of them ceased to exist or suffered losses that essentially destroyed all shareholder value. The fact is that when stocks are bought for the long run, capital destruction is virtually guaranteed.

So, is there an alternative approach to diversification which does not rely on these flawed assumptions of conventional investment wisdom? The answer is proper portfolio diversification based on the distribution of risk across numerous Return Drivers. A Return Driver is the primary underlying condition that drives the price of a market. There is no magic intrinsic return provided by stocks. In fact, in the study we present here, we can identify the two primary Return Drivers of stock performance.

The essential assumptions of this alternative, Return Driver-based approach to diversification are as follows:

  • Every successful trading strategy or investment opportunity must be based on one or more fundamental Return Drivers that are the source of the performance.
  • By distributing risk across numerous Return Drivers, no single event or condition can destroy the value of your portfolio.
  • Every Return Driver has a relevant time period over which it is effective.

So, if stocks do not provide an intrinsic return, then what actually drives stock market performance? In other words, what are the relevant Return Drivers of the stock market? The apparent intrinsic return from investing in U.S. stocks over the past 100+ years was really just the result of two primary Return Drivers:

  • The aggregate profit (or earnings) growth of the companies that comprise the market.
  • The multiple that people were willing to pay for those earnings (i.e. the Price/Earnings or P/E ratio)

The figure below displays the relative contribution to stock prices -- represented by the S&P 500 (SPY) Total Return Index -- by each of these two Return Drivers. Together, they account for more than 90% of the S&P 500's returns.

Source of Returns

S&P 500 Total Return Index

Click to enlarge.

The graph shows that in any period of less than ten years, earnings accounted for less than 25% of the price change in the S&P 500 TR index, while changes in the P/E ratio accounted for more than 75% of this price change. It is only over the longest periods of time that earnings come to be the dominant Return Driver.

Most importantly though, this shows that what appears to be an intrinsic return of the market is simply the aggregate result of corporate earnings coupled with the enthusiasm (sentiment) people have for buying stocks.

As the graph shows, sentiment dominates short-term stock performance. Over shorter time periods, stock prices are driven more by the psychology of people buying and selling stocks than by corporate earnings, as the following example illustrates.

In 1999, Jack Welch was at the top of his game. He had been anointed "Manager of the Century" by Fortune magazine, and it was under his leadership that General Electric (GE) became widely acknowledged as one of the world's best-run corporations. World-wide adulation for Mr. Welch and GE was reflected in the company's stock price.

GE was highly profitable, earning $1.07 per share in 1999 (accounting for a stock split in 2000). At the end of 1999, GE stock closed at a split-adjusted $38.06 per share and sported a P/E multiple of 35. Eight years later, during 2007, GE earned $2.20 per share, a 105% increase over the earnings for 1999. Yet the stock price closed at just $33.06. Despite strong earnings growth over the eight-year period, the stock price actually fell 13%.

How is this possible? In order to answer this question, we need to examine the proper Return Driver. The divergence between GE's stock price and its earnings is explained by the dramatic decline in the P/E ratio that people were willing to assign to the stock, which fell from more than 35 in 1999 to just 15 by the end of 2007.

The myth of intrinsic returns is one of the most pervasive of all investment myths, but there is no magic of intrinsic returns. Conventional wisdom - that national and international economic growth powers stock returns - is not only wrong, the direct opposite is closer to the truth.

Over the short term, stock prices are driven far more by people's demand (sentiment) as measured by changes in the P/E ratio than by the company's actual earnings. It is only over the longest periods of time that corporate performance (earnings) becomes the more important Return Driver.

Understanding the primary factors (the Return Drivers) that drive stock prices will allow you to invest in stocks intelligently and with the conviction that over time the positions will provide returns that exceed those achieved from random stock selection or from simply buying the market.

For a further explanation of Return Drivers, please see jackassinvesting.com.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: What Drives Stock Market Performance?