10 truths about the stock market

This post was originally published on TKer.co on October 15, 2021.

The stock market can be an intimidating place: there is real money at stake, there is an overwhelming amount of information to keep track of, and people have lost fortunes in it very quickly.

But it is also a place where thoughtful investors have long accumulated great wealth.

The main difference between positive and negative results is related to misconceptions about the stock market that can lead people to make poor investment decisions.

With this in mind, I present to you ten truths about the stock market.¹

There is nothing the stock market hasn’t overcome.

“In the long run, the stock market news will be good,” wrote billionaire investor Warren Buffett, the greatest investor in history, in an op-ed for The New York Times during the depths of the global financial crisis. “In the 20th century, the United States endured two world wars and other traumatic and costly military conflicts; the Depression; a dozen recessions and financial panics; oil crises; a flu epidemic; and the resignation of a disgraced president. Yet the Dow Jones rose from 66 to 11,497.”

Since that op-ed was published, the market has emerged from the global financial crisis. He also overcame a U.S. credit rating downgrade and a global pandemic, among many other challenges. The Dow closed Thursday at 34,912, just 2% from its all-time high.

By the way, historically it was not necessary to wait a hundred years to obtain positive results. Since 1926, there has never been a 20-year period in which the stock market has not generated a positive return.

While stocks typically rise over much shorter periods, the odds of positive returns improve as lengthen your time horizon.

For more information, read: In the stock market time pays ⏳ and A very long-term chart of US stock prices that tend to rise 📈

Bull markets present many obstacles along the way.

While the S&P 500 has generally generated positive annual returns, it has also experienced an average decline (i.e., a decline from its peak) of 14% over those years.

The chart below from JP Morgan Asset Management does a good job of illustrating this. The gray bars represent performance for each calendar year and the red dots represent within-year declines.

Bear markets are not an easy day either: they can happen quickly, like the S&P500’s 34% drop from February 19, 2020 to March 23, 2020; and they can occur painfully slowly, like the 57% drop between October 9, 2007 and March 9, 2009.

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

For more information, read: Stomach-churning stock sell-offs are normal🎢, My favorite visualization of short-term stock market performance 📊, and Bearish markets and a truth about investing 🐻

At some point in your life, you’ve probably heard that the stock market generates about 10% annual returns on average.

While this may be true over the long term, the market rarely offers an average return in any given year.

See the chart below from Ben Carlson of Ritholtz Wealth Management. Plot the annual returns of the S&P 500 since 1926. If 10% returns were common, you would see a narrow horizontal line of dots just above the x-axis.

This chaotic mess of points illustrates how difficult it is to predict what next year’s returns will be. This is true even if you know exactly what is going to happen in the economy. Outside of the Great Depression and the global financial crisis, it is difficult to distinguish the major economic booms and busts in history.

The good news is that most of the points are above the black line. In fact, stocks often go up.

For more information, read: Don’t Expect Average Stock Market Returns This Year 📊, Don’t be afraid of the market bears 🐻, and 2 Revealing Charts About the Volatile Trajectory of the Stock Market📉📈

A stock can only go down 100%, but there is no limit to how many times that value can be multiplied when going up.

Yes, we’ve seen some pretty bad sell-offs in the stock market. But it has increased many times more. It is not guaranteed, but it is offered. Since its low of 666 in March 2009, the S&P 500 has risen more than six-fold today.

For more information, read: The Incredible Asymmetric Advantage of the Stock Market 📈, There are more advantages than disadvantages for long-term investors 📈, and Warren Buffett reminds us how extraordinarily difficult it is to pick winning stocks 🤓

Any long-term movement in a stock can ultimately be explained by the performance of the underlying company. earningsearnings expectations and uncertainty about those earnings expectations.

News about the economy or policies moves markets to the extent that it is expected to affect earnings. Profits (also known as profits) are the reason for investing in companies.

For more information, read: Earnings are the most important driver of stock prices💰, Peter Lynch made a remarkably prescient market observation in 1994 🎯, and Publicly traded companies are not charities 💸

There are many valuation methods that will help you estimate whether a stock or stock market is expensive or cheap. We won’t go over them all here.

While valuation methods can tell you something about long-term returns, most tell you almost nothing about where prices are headed over the next 12 months. In short periods like this, expensive things can become more expensive and cheap things can become cheaper.

It is worth noting that prices can be cheap or expensive for long periods of time. In fact, some people would say that valuations are not mean reverting.

For more information, read: The Stock Market’s Complicated Evolving Relationship with Valuations 📈, Use valuation metrics like P/E ratio with caution ⚠️, and Goldman Sachs busts one of the most persistent myths about investing in stocks 🤯

Investing in stocks is risky, so the returns are relatively high.

Even in the most favorable market conditions, there will always be something that will keep the most risk-averse people on the sidelines. For more information, see Yahoo Finance Morning Brief’s decade chart.

For more information, read: We’re sorry, but uncertainty will always be high. 😰 and Two recent cases in which uncertainty seemed low and confidence high 🌈

Surveys of market participants will produce lists of the top risks, and ironically, the most cited risks are those that are already priced into the markets.

It is the risks that no one talks about or that few care about that will shake the markets when they come to the surface.

For more information, read: The most destabilizing risks for the stock market 📉, For markets, there is something worse than bad news 📉📈, and A balance of the ‘risk factors’ of American companies⚠️

Just as most companies don’t last forever, most stocks don’t stay on the market forever. The S&P 500 sees a lot of churn (that is, failing companies are removed and promising companies are added).

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

For more information, read: More than 700 reasons why investing in the S&P 500 index is not very “passive”💡 and The composition of the S&P 500 is constantly changing 🔀

While the performance of the US stock market is closely related to the trajectory of the US economy, they are not the same.

The economy reflects all the business done in the United States, while the market reflects the performance of the largest companies, which typically have access to lower-cost financing and have the scale to obtain cheaper goods and labor.

Importantly, many of these larger companies that make up the stock market do at least some business abroad, where growth prospects may be better than in the United States.

For more information, read: The stock market is not the economy in any important way 🌎, 4 Key Observations About the US Stock Market to Remember 📊, and The ‘critical’ consumer shift that could define stock market performance in 2024 🔀

It is very possible that we are on the verge of a terrible bear market that will last several years. Who knows?

However, the stock market has a bullish bias.

This makes sense if you think about it. There are many more people who want things to be better, not worse. And that demand encourages entrepreneurs and companies to develop better goods and services.

And the winners in this process grow as income increases. Some even grow enough to be listed on the stock market. As income grows, so do profits.

And profits drive stock prices.

This post was originally published on TKer.co on October 15, 2021.

¹ “Stock market” is a general term often used to refer to the major US indices: the Dow Jones Industrial Average, the S&P 500, and the Nasdaq. When I refer to “stocks,” I typically mean the S&P 500. When I discuss specific statistics, I will be explicit about what I’m talking about.