Most people in finance, at least those who share their ideas publicly, believe that the stock market will always go up in the “long-term”. What’s more, many are married to a specific rate of return, assuming this is the “equilibrium” for the market.
Many strategies seem to imply that the stock market will enjoy a certain rate of return- or at least a certain advantage over fixed income (the Equity Risk Premium). Many more assume this gap will be large, or the return to be at some set level.
How confident can we be about these assumptions? Over what time periods are they more likely to be true? What are the consequences of them not being true?
It’s always going up baby!
Believing that some financial asset/product is always going up in price has historically ended in tears. It sounds like some kind of scam, and usually is. “Tulip prices won’t drop, look at the increase over the last month!” Ok, Stijn.
However, in this case there are legitimate reasons to believe this might be the case for a given stock market as a whole. There are some logical-sounding arguments for this belief.
The nature of stocks as an asset class drive prices higher. They have unlimited upside and a limited downside. Big drops, although painful at the time, create an attractive opportunity for investors. For example, if stocks drop 50% it isn’t too hard to picture them going back up to this level. If they do, that’s a 100% gain, not a 50% gain. Easy money.
This is self-fulfilling and self-feeding: if people believe stocks are an attractive investment they will buy stocks, pushing the price higher. This makes stocks appear to be an attractive investment, which leads to more investors purchasing stocks…
Stocks are not like gold. They are based on reality, on real companies. They represent a share of a business. If that business becomes more and more successful, it will generate more and more profits and shareholders will receive more income. It is hard to imagine the price you must pay to acquire a share of this income not increasing as a result of the sustained increasing profitability of a company.
Reality is also the reason why you would think that the income derived from stocks would be greater than that derived from bonds. The holders of bonds are more likely to be paid back than stockholders in the case of bankruptcy of the company. Therefore, stocks must offer a higher rate of return relative to bonds. Otherwise investors would simply purchase bonds. Using the same logic, this is why the rate of return on corporate bonds must be higher than the rate on domestic government bonds. The government is probably less likely to go bankrupt than a specific company (especially if it can print money to pay off debt).
Profits up = stock market up
As I briefly discussed above, it seems reasonable to believe that as the profits of a company increase, it’s share price increases as well (roughly). So, as long as the profits of the companies that compose the market increase, the market as a whole should increase in value.
Why would these profits increase?
- Increasing population. As the population increases, there are more people to buy things. Companies sell more things and make more revenue. This typically equates to more profit.
- Increasing productivity. As productivity increases, companies can produce the same output for lower cost/time/effort. This increases their profitability.
- Inflation. As price levels in general increase, the prices of things companies are selling increases. This leads to more revenue. All other things being equal, this will lead to higher profit.
What’s more, the market only keeps the winners. If a company starts to see a serious decline in profitability, it may be removed from the aggregated market. As long as the profitability of companies increases as a whole, the stock market “should” go up.
Everyone wants it to
Hedge funds aside, pretty much everyone wants the market to go up. Always. A rising market means more money in your investment account, more money to live off in retirement, more money in the pockets of executives, higher bonuses for financiers, more praise for the leaders of countries, more lavish parties, and more champagne. It’s great. For everyone.
As mentioned earlier, a booming market is self-feeding and the desire for the market to go up can be self-fulfilling. We are also seeing this attitude being displayed more and more by central banks and governments. They are intervening, albeit usually indirectly, to push market prices higher. I don’t see this trend reversing any time soon as long as the risks of doing so remain hidden.
Although these arguments seem convincing on the face of it there are reasons to pause before swiftly depositing your life savings into a FTSE 100 ETF. There are reasons to be more careful.
Markets as Complex Adaptive Systems
Markets are complex. They are adaptive, dynamic and exhibit emergent properties.
What does this mean for proponents of the perpetual increase hypothesis?
The future may not be like the past
“The market has historically risen 5% and will therefore always go up 5% in the long-run.” This is a dangerous assumption to make, for a variety of reasons. The market is like an organism. It’s constantly adapting to its environment. It does not exist within a vacuum with set rules. Anything can happen. Algorithms may go haywire. Retail investors using apps could cause massive bubbles and subsequent crashes. Trading could be heavily taxed and become far less appealing/profitable. The list of things that could happen is infinite. Some could be permanent. Some could change market dynamics forever.
This is the problem of applying induction outside of iid observations (1). It’s hard to arrive at meaningful conclusions using empirical data. History shows us what could happen not what will happen.
An equilibrium may not exist
Why should the market have some equilibrium return that we always observe in the long-term? What is the reason for this? And why is this different country to country? Will US companies always be better than Brazilian companies? Maybe not. Then why would the US stock market have a higher equilibrium return in the long-term?
I see no reason for this.
The system may move to a new equilibrium without warning
Even if markets were in some kind of equilibrium, what’s to stop them from moving to a new one? We have seen this with the global climate. The Earth’s temperature is constantly moving to new equilibriums (the Earth was covered in ice just 18,000 years ago). What’s to stop something similar happening with stock markets?
Profits may not always increase
Might businesses stop increasing their profits at some point? This seems possible.
The population can not perpetually increase. We are already seeing this in developed nations. A lower population means fewer consumers of your product, less revenue, and lower profits.
Inflation does increase the nominal profits that a company generates. But it is only nominal profits. This could lead to a nominal increase in the share price but not a real one. My point here is that investors should only care about real returns. Increases in share price that are uniquely driven by inflation are not beneficial in a broader context. In fact, I would propose that the inflation in share price is normally not as high as the inflation in the economy. Not a good thing for investors.
As stated above, history tells us what can happen, rather than what will happen or even what is likely to happen. So let’s look at what can happen. Jorian and Goetzmann (2) studied the global performance of stock markets in the twentieth century. They found that for all countries looked at from 1921 to 1996 aside from the US, the median real return was a mediocre 0.8%. Negative real returns over observed periods were not uncommon. In fact, the mean real compounded return for all 39 countries looked at was -0.47.
Now, it’s possible that this was just a particularly bad period. But this doesn’t matter. The burden of proof is not on those who are sceptical of the stock market’s unlimited growth potential. Negative real returns have happened over extended periods in multiple markets. This indicates that this scenario is possible.
What does this mean for investors?
What does this all mean for investors? Broadly speaking, I see no clear reason why it will necessarily be the case that the stock market should go up in the long-term. I see even fewer reasons as to why markets should return some set level of return “based on empirical evidence”.
Life happens before the limit. Investors don’t care about the true long-term return, only nerds do. What investors care about is the return they will experience, or are likely to experience. For those practising lifetime investing, this period is somewhere between 50 and 100 years.
So it doesn’t really matter what the market does “in the long-term”. It only matters what happens to you. Therefore, you should only be concerned as to what could happen in any given 50-100 year stretch.
The dangers of assumption
Much more important than the accuracy or validity of ideas or predictions is the consequences of those beliefs.
What are the consequences of believing the stock market always goes up in the long-term, if it actually doesn’t?
This will probably lead to unrealistic expectations of equity returns. You may have a lot of stocks in your portfolio as a result of this. When stocks crash, you’re gonna get burned. Badly. You may be shocked when your portfolio doesn’t perform as well as you hoped for. This can be disastrous for retirement plans, for example.
Generally, stocks are accompanied by more uncertainty than most financial assets. This uncertainty comes with a cost. If the perception of the benefits of holding stocks is inflated, the actual benefits of holding stocks may be significantly lower than risks associated with holding stocks.
What are the consequences of doubting the stock market always goes up in the long-term, if it actually does?
First, let’s assume that this always translates to our time-frame of 50-100 years. The main downside of this is that we would not receive as much of the upside that stocks offer. The Equity Risk Premium is there for a reason. However, when there is more uncertainty, decision-making becomes easier. In this scenario, the more uncertainty that is present about the risks and returns of assets, the more we can confidently move towards a 1/n portfolio composition. We would still receive some of the benefits of holding stocks, just not as much as other investors.
As with nearly everything in life, there is no clear and obvious answer. I believe we have reasons to doubt that all markets always go up in the long-term. Looking at history we can see that some markets have not risen in 50-100 year periods. I don’t see why this can’t happen again. The idea that markets have some set level of return that they always drift towards is even more doubtful. This belief has clouded the minds of some American investors in particular who dominate, like they do in most other areas, the global investment conversation. The S&P has delivered remarkable returns over the last century (the average annualized total return over the past 90 years is 9.8%). This has led to an over-confidence in equities and their ability to deliver returns.
Do I believe the stock market of any single country is guaranteed, or close to guaranteed, to rise over a 50-100 year period? No. For the global market as a whole, however, this is less clear. You would expect global markets to rise as long as global GDP rises. It’s hard to imagine a world in which this isn’t happening as productivity exponentially improves and more and more global citizens escape poverty. Jorian and Goetzmann (2) found that from 1920 to 1996, a global index of all the markets they looked at had a real geometric return of roughly 4%. That’s pretty good. An extended contraction in global GDP is currently unfathomable. Most of the scenarios in which this could occur involve situations in which your investment account would be the last of your worries.
(1) Big Davey Hume had some things to say about this. From his wikipedia page: “This problem of induction means that to draw any causal inferences from past experience it is necessary to presuppose that the future will resemble the past, a presupposition which cannot itself be grounded in prior experience.”
(2) Jorion, P. and Goetzmann, W.N., 1999. Global stock markets in the twentieth century. The journal of finance, 54(3), pp.953-980.