Our common sense understanding of investments is that they are supposed to offer us something in return for an initial outlay, in our case money. Whether those gains are realized immediately or in several years, is something each individual investor has to think about and see if the particular project is worth going into, and we all seem to understand this notion as a real rate of return.
So when I saw the Wall Street Journal publish this article on real returns, I was a little puzzled. My impression from going through many of WSJ’s articles was that a lot of the basic financial concepts are considered to be common-ground when trying to decide if market developments are newsworthy or just flashes in the pan; however, history seems to suggest that many investors might be misinterpreting what a real return actually is and paying dearly for it.
This notion seemed counter-intuitive at first, but upon glancing down the article, I found that the article talked extensively about the role inflation has played in the valuation of portfolios that are typically diversified. It brings up the example of taking $10,000 and investing it at 10% a year for 20 years. By the end of that time with no inflation, you would have roughly $70,000. With 3.5% inflation, that $10,000 only hits $20,000. Not a bad return by any means, but not what you would expect from a 10% annual return. Based on this logic, if we used 1950’s trading volume as a baseline for what is considered normal, the Dow should be worth only 10,000 as opposed to the 16,400 it’s worth now. Another explanation is that in the 1950s, on average stocks were trading at 11 times the previous year’s earnings and that was previously considered a clear sign of a booming bullish market; however, in 1982 prices were revised upward. Since then, stocks have traded at approximately 18 times the previous year’s earnings creating a lot more bubble potential than ever before.
Does this mean that we’ve permanently revised stock expectations so that they will always be too high? Potentially yes. Forbes did an article last October on stock valuation, and they found that historical generational bull markets start when average price/earnings ratios based on the Shiller Index reached 7 or higher. In 2009, widely considered to be the low-point of the recession, the average stock was trading with a P/E ratio of 14. This indicates a very bullish market by the Shiller index even though the exact opposite was occurring. Upward revisions in trades have essentially rendered the historical Shiller index meaningless. After all the adjustment in 1982 was designed as a response to excessive inflation and probably intended to persuade investors to put their money towards stocks and away from highly inflated bond prices at the time. Right now the economy is facing the opposite problem. Inflation is still not close enough to the historical average and is only continuing to inch its way towards 2%, so that means high price earnings ratios should be treated with caution. So the problem doesn’t appear to be just in an investors fundamental understanding of real rates of return, but it appears to be a systematic problem which has misled some investors into believing that almost every stock is strong based on a historical average. This leads to unreasonable expectations, or a false-bull market and can often times lead to inefficient “flights to quality” like we saw in January.