“The price you pay determines your future returns” is an old adage in financial literature. This is a simple way of saying that when you buy at high prices, your future returns are lower. Conversely, when you buy at low prices, your future returns are higher. Buy low, sell high. It all sounds right, but is it true? Or is this phrase just an antiquated relic of times past when money did not grow on government balance sheets, and asset prices didn’t always go up? That is a fair question, but it is not a simple one.
An important distinction
The stock market is a dynamic marketplace where individual stock prices move in different directions daily. Most investors understand that some companies and sectors decline while others increase. Under normal circumstances, this aspect of the capital markets is an invaluable tool in allocating resources and increasing productivity. What many investors do not understand, however, is that in times of euphoria induced by the Dukes of Moral Hazard, share prices tend to move in the same direction.
When bubbles form in a particular asset class like US equities, the fear of missing out takes over. The disparity in healthy market behavior gives way to a tendency for all stocks to rise beyond what normal market conditions would bear. As a result, even otherwise solid companies may be a horrible long-term investment. In short, beware of the price you pay, or you may pay the price.
Are we in a bubble?
Based on a wide variety of measures, the U.S. stock market is more expensive than it has ever been. That includes the peak of 1929, right before an 80%+ decline during the great depression. It includes the peak of the Dot.com bubble in 2000, right before a decline of 50% in the S&P and over 80% in the Nasdaq. And it includes the peak right before the credit crisis in 2007, where the stock market declined approximately 45%. Simple put, based on historically reliable measures of stock prices, the price for U.S. stocks today has never been higher.
One of these measures provided below by John Hussman is of corporate earnings from a rolling 10-year period divided into the current price of the S&P 500 index, adjusted for abnormalities in profit margins. If I just lost you, let me summarize: the graph indicates how much investors are willing to pay right now for shares of companies that comprise the S&P 500 index. This valuation metric correlates strongly with subsequent 10-year returns. That is, it fairly accurately predicts what the market is likely to do over the next decade. And today, it’s suggesting U.S. equities will have negative returns over that time period.
Historically, investors have been willing to pay somewhere in the range of 15-20 times the earnings of the stocks that comprise the S&P 500. If investors are paying 10 times earnings then stocks are, historically speaking, on sale. If investors are paying 30 times, as they were during the credit crisis in 2007, the market is expensive. Today, investors are paying nearly 50 times earnings. Now some “experts” in the financial media insist that bubbles are not recognizable until after the fact. But at prices that exceed the dot.com and real estate “bubbles”, calling current prices a bubble is somewhere between likely and obviously true.
Owning “good” companies
Many investors can sense we are in a bubble, but they still think owning good companies will protect them. Amazon, after all, is not going anywhere. Neither is Apple. There is every reason to believe these companies will continue to grow their earnings. So, what is the worst that could happen?
Below is a chart provided by our friends at Research Affiliates, showing the largest companies in the world by the size of their stock price, for each decade over the past 40 years.
The first thing to notice is that the names at the top are constantly changing. Companies whose stock prices have performed well for a decade or more often underperform over the next decade. Second, some of these companies did not even exist by the turn of the next decade (e.g., Lucent). Third, and perhaps most important, many of these companies increased their earnings, only to see their share prices perform poorly anyway (e.g., Cisco, Exxon, IBM, etc.).
Let me say that again. If investors pay a high price for a “good” company, during a euphoric bubble, they may continue to pay the price over the next decade or beyond. Cisco, for example, has doubled its earnings per year over the past 20 years. That should be good for its stock. Unfortunately, Cisco’s stock price is still 30% below its peak in 2000. Was Cisco a good investment? Well, if you define good as owning shares of companies that will continue to grow revenues, then sure. But if your goal is to increase the value of the money you invest over the long run, then Cisco was a horrible long-term investment.
Nippon T&T, one of the largest telecommunications companies in the world, has continued to grow its revenues since 2000. At the same time, its stock price remains nearly 40% below its peak in 2000. And these are examples of some of the companies that survived.
Why does this matter?
There is a pervasive deception lurking behind every Robinhood or Reddit profile in America these days. Many individuals recognize that most “meme stocks” are a joke. Perhaps some see them as a speculative gamble, or maybe just a principled way to stick it to the man. What many individuals do not understand is that some of the largest, most financially secure companies in the world may not be much better than meme stocks in terms of long-term investment potential. At least not at today’s prices.
Of course, there are still good companies (and assets) whose share prices are relatively attractive today, both inside but especially outside the US equity markets. Our investment process is focused on identifying such opportunities. But if history is any indication, not only will the S&P 500 perform poorly over the next decade, but even companies like Apple, Amazon, and Walmart could. These behemoths could feasibly continue to dominate the landscape. They could benefit from easy money, government largess, and over-regulation of competitors. They could even increase their earnings considerably, and yet still see their stock prices fall over the next decade.
The price you pay determines your future returns. It is not just a pithy old adage, it’s a warning to those who neglect the history of financial markets…and pay the price instead.