John Maynard Keynes
“It’s dangerous … to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.”
Some investors foolishly try to generate short-term returns in the stock market, and in doing so, they overlook that when stock returns depart meaningfully from the long-term norm, it is rarely because of corporate earnings growth and dividend yields. Instead, annual stock returns can be volatile largely due to the “emotions” of investing.
Investor emotions can express themselves in the price/earnings (P/E) ratio, which measures the number of dollars investors are willing to pay for each dollar of earnings. As investor confidence fluctuates, the P/E multiples rise and fall. When investors get greedy, we see high P/Es. When investors are afraid, P/Es tend to be low. These swings in the P/Es have a single effect: they create noise in the otherwise quite steady long-range upward trend in the economics of investing.
Therefore, if we can distinguish why the past was what it was, we can establish a reasonable expectation about the future. The famous English economist Keynes tells us that the state of long-term expectation for stocks is a combination of “enterprise” (or forecasting the prospective yield of assets over their lifespan) and “speculation” (or forecasting the psychology of the market).
Look at average annual investment returns on stocks over the decades since 1990. You can see that the contributions of earnings growth to investment return, except for the depression in the 1930s, was positive in every decade, usually running between 4 percent and 7 percent. This means that total investment returns were negative in only a decade; businesses' gains were steady. Compared with the consistency of dividends and earnings growth, there were wild variations in speculative return – the quiet 1910s and then the roaring 1920s, the dispiriting 1940s and then the booming 1950s, the discouraging 1970s and soaring 1980s.
When we combine these two sources of stock returns, we see that despite the huge impact of speculative returns in the short-term, there is ultimately no lasting long-term impact. The average annual total return on stocks has been created almost entirely by the “enterprise” component. The message is clear: In the long run, stock returns depend almost exclusively on the investment returns earned by corporations, and investors' perception counts little. Economics controls long-term equity returns, not emotions. And, closing the loop to the famous Keynes quote, knowing that can help predict the future with a little more ease and accuracy.
Links for Further Reading:
Who was John Maynard Keynes – https://en.wikipedia.org/wiki/John_Maynard_Keynes
Short BBC video on predicting the future – https://www.bbc.com/reel/video/p0dwntct/can-you-learn-to-predict-the-future-
Rich Quora blog on why it is so hard to predict the future – https://www.quora.com/Why-is-it-so-difficult-to-predict-the-future-accurately
