10 Realities About the Markets

10 Realities About the Markets

The stock market can be a frightening place: it is real money at risk, there is a tsunami of noisy information that floods the news headlines daily, and it is possible to lose fortunes, in some cases, almost instantaneously.

Conversely, it is also the place where pragmatic and prudent investors have long accumulated a significant amount of wealth for them and their families.

The primary difference between those two diverging outcomes is related to proper risk-management. Common misbeliefs can lead investors to make poor investment decisions so, to the extent possible, de-mystifying these beliefs can positively tilt an investor’s outcome.

1) The Long-Game is Undefeated
Regardless of any and all challenges (and there is no shortage of them) there is nothing that the stock market has not overcome.

Billionaire investor, Warren Buffett, exclaimed: “Over the long term, the stock market news will be good”. Buffett, deemed by many as the greatest investor in history, wrote in 
a piece for The New York Times during the height of the global financial crisis in October 2008. “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

Since Buffett’s piece was published in 2008, the market emerged from the global financial crisis, and went on to face a U.S. credit rating downgrade and a global pandemic, among many other challenges, yet the companies, with intelligent management teams, found ways to adapt, modulate their business models, and find new ways to successfully emerge from whatever headwind they were faced with. 

Since 1926, 
there has never been a 20-year period where the stock market did not generate positive returns for investors. Ever. While stocks almost always go up over much shorter periods, the odds of positive returns improve as investors lengthen their time horizon.

2) Investors can get shocked in the short-term
Market’s incessant ascend can also come with a lot of bumps in the road.

The chart from J.P. Morgan Asset Management illustrates this well. The bars represent each calendar year’s return, and the red dots represent the intra-year drawdowns.

While the S&P 500 typically generates positive returns, it has also seen an average drawdown (decline from its high) of 14% during those years.

And bear markets are no picnic either. They can happen fast. For example, the S&P 500 dropped 34% from February 19, 2020 to March 23, 2020. However, they can happen painfully slowly too. For example, the 57% decline from October 9, 2007, to March 9, 2009.

Investing for long-term returns means being able to stomach a lot of intermediate volatility

3) Never expect average returns
Going back to 1927, the U.S. stock market’s long-term return is about 8% annually. 

While that may be true in the long run, the market 
rarely delivers an average return in a given year.

Ben Carlson plots the S&P 500’s annual returns since 1926. If average returns were commonplace, we would see a horizontal line of dots just above the x-axis, but we don’t.

This chaotic mess of dots shows just how difficult it is to predict what the next year’s returns are going to be. This holds true even if you know exactly what’s going to happen in the economy. Outside of the Great Depression and the Global Financial Crisis, it is extremely difficult to foresee history’s major economic booms and bust. The good news is that most of the dots are above the black line. Take away: stocks usually go up.

4. Stocks offer asymmetric upside
A stock can only go down by 100%, but there’s no limit to how many times that value can multiply going up.

We have seen bad selloffs in the stock market (with two particularly bad market meltdowns in the last 3 years). But the stock market has gone up manyfold more. It is never a smooth ride or a straight line, but the stock market increases more than decreases. From the low of 667 in March 2009, the S&P 500 is up more than 600% today.

5. Earnings ultimately drive stock prices
Long term moves in a stock can ultimately be explained by the company’s underlying earnings, and uncertainty about the expectations for earnings.

News about the economy or policy moves markets to the extent that they are expected to impact earnings. Earnings (otherwise known as profits) are why we invest in companies. Investors want a claim on the future cash flows of the company.

6. Valuations won’t tell you much about next year
There are multiple different valuation methods to determine the relative cost of a stock. 

While valuation methods may tell investors something about long-term return performance, most valuation metrics 
tell you almost nothing about where share prices are headed in the next 12 months. Over short periods, expensive things can get more expensive and cheap things can get cheaper.

Prices can be cheap or expensive for extended periods of time. Rarely does today’s valuation have any meaningful correlation to next year’s performance.

7. There will always be something to worry about
Investing is risky, which is why investors, over time, earn their returns. 

Even in the most favorable market conditions, there will always be something that will keep the most risk-averse investors on the sidelines.

Examples of reasons why not to invest in the last 10 year: European Union Sovereign Debt Crisis, US Debt Downgrade, China hard landing, Eurozone deflation, Brexit, quantitative tightening, trade war, Chinese credit tightening, inflation, bond crash, Covid, Ukraine War, et cetera.

8. The largest risks are the ones that people are not talking about
Surveys of market participants will yield lists of top risks, and ironically the most commonly cited risks are the ones that are already priced into the markets.

In reality, it is the risks that no one is talking about (or very few are concerned about) that till ultimately be the most disruptive to markets when they surface.

9. There is turnover in the stock market
NO businesses in immortal. Most businesses do not last forever, and most stocks are not in the market forever. The S&P 500 has a lot of turnover (i.e., failing businesses are removed, and up-and-coming businesses are added).

In fact, it is the addition of new and unexpected companies that have been driving much of the S&P 500’s returns over the past decade.

Fun fact: since 1980, more than 35% of S&P 500 constituents have turned over during the average 10-year period. That was as high as 45% in the 2000’s. These measures are similar in the Canadian stock market.

10. The stock market is not the economy
While the stock market’s performance is tied to the trajectory of the domestic economy, the economy and stock market are not the same thing.

The economy reflects all the business being conducted in the U.S. [or Canada] while the market reflects the performance of the largest, public companies — which typically have access to lower-cost financing and have the scale to source goods and labor more cheaply than the broad economy. 

Goldman Sachs suspects that upwards of ~30% of S&P 500 revenues are derived from a company’s international operations, reinforcing the fact that bigger companies do 
business overseas where growth prospects may be better than in the U.S.

In 2022, the S&P 500 dropped over 19%, while the 
economy actually grew 2.1%. The stock market and the economy have significant influence over each other, but the correlation between the two is surprisingly weak.

: This information is not investment advice This information is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This information is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof.