What Drives Returns

John Coumarianos, via MarketWatch, penned a very interesting note recently with respect to the view that it is just “volatility” is driving prices.

“The great economist John Maynard Keynes once said: ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.’

Few recent writings display this phenomenon better than a blog post by Josh Brown, aka The Reformed Broker, the title of his well-read (usually deservedly so)website.

Brown’s post, cleverly titled “Why the stock market has to go down,” incorrectly asserts that volatility is ultimately what rewards stock investors who have the ability to withstand it.

This is the standard talk that most advisers give their clients. It comes from the academic ‘efficient markets’ or ‘random walk’ school of thought. And it is totally wrong.

The truth is that the stock market doesn’t owe you anything, no matter how volatile it is and no matter how long you wait.”

This is absolutely true. What drives stock prices (long-term) is the value of what you pay today for a future share of the company’s earnings in the future. Simply put – “it’s valuation, stupid.” As John aptly points out:

“Stocks are not magical pieces of paper that automatically deliver gut-wrenching volatility over the short run and superior returns over the long run. In fact, we’ve just had a six-year period with 15%-plus annualized returns and little volatility, but also a 15-year period of lousy (less than 5% annualized) returns.

It’s not just volatility; it’s valuation.

Instead of magical lottery tickets that automatically and necessarily reward those who wait, stocks are ownership units of businesses. That’s banal, I know, but everyone seems to forget it. And it means equity returns depend on how much you pay for their future profits, not on how much price volatility you can endure.”

“And stocks are not so efficiently priced that they are always poised to deliver satisfying returns even over a decade or more, as we’ve just witnessed for 15 years. A glance at future 10-year real returns based on the starting Shiller PE (price relative to past 10 years’ average, inflation-adjusted earnings) in the chart above tells the story. Buying high locks in low returns and vice versa.

Generally, if you pay a lot for profits, you’ll lock in lousy returns for a long time.”