In Spite of Press Doom and Gloom, Implied Returns on Stocks Look Good

This is outright shocking - according to a recent Wall Street Journal article (link here - subscription might be required), if you bought the S&P 500 index in April 1999 (9 years ago), you would be slightly underwater. I'm surprised the article chose that period - if you had bought in March 2000, you would be down almost 10%.

I love it when the press states the obvious as if it is news. Perhaps the next article in the series should be: "if you bought real estate in South Florida in 2005, you would have lost money".

The key point to remember is that this is a case of selective time period. Mutual Fund managers and money managers are experts of picking the right time period and parsing performance data to make themselves look good. This article is a case of the opposite - picking the worse time period possible to generate the bleakest headline.

If you had bought the S&P 500 in the Summer of 2002, you would be up roughly 75%. We can keep picking odd time periods and get all kinds of wacky numbers.

The fact is that the bubble of 1998-2000 was an anomaly - it was not representative of the long-term stock market trend - neither the peak nor the trough. Granted, that is little comfort to the guy who bought technology stocks in early 2000, but it is important to keep the right perspective.

The secular bull market of the 1980's and 1990's was driven primarily by the decline in long-term real interest rates, with secondary pushes from productivity increases and profitability improvement, in my opinion.

The best way to determine what to expect from the long-term in the stock market is to estimate what the implied discount rate is as reflected in the current price. Many of the blue chip stocks I follow imply a discount rate approaching 15% annually, according to my estimates. This compares with my estimates of 6-7% at the peak in 2000.

Of course, if long-term real interest rates go up, then that return will be undermined. Two things might drive those rates up - adverse demographic changes (not likely), and structural economic uncertainty (such as political instability or a decisive move towards a more socialistic government). Other things that influence rates are market structure and stability, transparency, and efficiency.

What about inflation? In the short-term, inflation is bad news for stocks. However, inflation means that companies gain pricing power, meaning that profits will move up faster over time to compensate for the inflation. This is more true for some companies than others. The problem with inflation is not its direct impact on stocks, but the fact that it introduces uncertainty and inefficiencies into the economic system. It is, in fact, an indirect tax on the economy.

The gist of the matter is that implied returns look pretty good right now, despite the short-term market volatility.

Comments

[User 168790:]

Press is very often blowing things up. If they said everyday: "Don´t worry, tomorrow will be the same as today.", then the papers would not sell. They have to keep blowing things up. They are not morally required not to do that, but we are not morally required to believe them.

2008 Mar 27 05:51 AM

[cynic69:]

Daniel
What are "implied returns"? I think that "implied returns" are generated by those who have a vested interest in the underlying. I think your polyanna notions of "implied returns" proves without a dought that you are long the market.
Gale Whitaker

2008 Mar 27 11:39 AM