The impressive performance of stocks over the past two years, particularly within the technology sector, can largely be attributed to improved company profitability. This begs the question: can this enhanced profitability be sustained in the future, or are current expectations overly optimistic? Examining long-term returns and earnings data provides valuable context for evaluating this critical question. While short-term market fluctuations are often driven by sentiment, long-term market performance is ultimately determined by the underlying value of the companies, reflecting the principle that the market is a weighing machine in the long run.
A review of historical data reveals a potential risk of mean reversion for stocks. The S&P 500’s 10-year annualized return through 2024 stands at 13%, surpassing the long-term average of 9.9% since 1928. More importantly, considering inflation, the 10-year annualized real return reaches 9.7%, exceeding the long-term average of 6.7%. These above-average returns suggest a heightened possibility of a return to more historical levels. However, past performance is not necessarily indicative of future results, and the continued growth in earnings could support sustained higher returns.
The intrinsic value of a company is tied to its future cash flow, as highlighted by Warren Buffett. While stock prices can deviate from their underlying value in the short term, earnings ultimately drive long-term stock performance. The S&P 500’s consistent ability to grow earnings beyond inflation underscores the wealth-generating potential of owning operating companies through stock investments. Since 1936, S&P 500 nominal earnings have grown at an annualized rate of 6.7%, outpacing inflation by 3% annually. The robust stock returns of the past decade coincide with above-average earnings growth, both nominal and real, particularly in the post-COVID period. Projected earnings increases for 2025 further support the idea of sustained profitability, which is crucial for mitigating the risk of mean reversion in stock returns.
Successful long-term investing requires a patient approach. Historical data reveals that stocks have delivered positive returns in 73% of individual calendar years, a figure that rises to 94% over a 10-year holding period. Bonds, represented by the 10-year U.S. Treasury Note, have a positive return in 79% of calendar years and a 100% positive return over 10 years. When considering after-inflation returns, stocks outperform bonds, particularly over the longer 10-year horizon. While short-term stock market declines can be significant, the long-term data suggests that for those with a horizon of at least a decade, equities offer a compelling case for wealth creation despite their inherent volatility.
It’s crucial to remember that the journey in equity investing is not without its bumps. The S&P 500’s 13% annualized total return over the past ten years, while impressive, is significantly below the historical high of 20.1%. Similarly, the real return of 9.7% is lower than the peak of 17.9%. Historically, stocks have experienced significant drawdowns, like the 49% decline during the technology bubble burst and the 57% drop during the global financial crisis. However, despite these periods of substantial volatility, stocks have consistently delivered the highest long-term nominal and real returns compared to other asset classes. The average intra-year decline of 14.6% over the last 53 years serves as a reminder of the potential for short-term fluctuations, even within generally positive trending markets.
While some observers express concern about a potential stock market bubble, citing elevated valuations and optimistic economic expectations, the improved profitability of companies, particularly in the technology sector, cannot be ignored. History has shown that markets can continue to climb even after periods of strong performance. Investors should periodically assess their risk tolerance, especially after periods of market growth, as portfolio allocations can shift significantly. Rebalancing back to target allocations between stocks and bonds is a prudent strategy for managing risk and weathering the inevitable market downturns. Maintaining a long-term perspective and avoiding panic selling during periods of volatility are key to achieving successful long-term investment outcomes.
