"In the business world, the rear-view mirror is always clearer than the windshield." – Warren Buffett
From the beginning of the twentieth century, decade after decade, the American economy has been expanding non-stop. It is arguably the greatest period of wealth creation, with the greatest advancements in science, medicine – every field of endeavour – in history. Conversely, the stock market has a very different history; long periods of stagnation followed by markets moving in a straight up trajectory. How is it possible that the economy and the market could be so different? Let's take a quick trip through this history which may give us some clues.
As shown in the accompanying table, the gross domestic product compound annual growth rate (CAGR) varies between low single digits to high single digits. The CAGR of the Dow index varies widely from the Roaring Twenties to the doldrums of the 2000s. What explains the difference between the fairly consistent economic growth of the U.S. economy over the past 116 years and the long periods of ebb and flow in the stock market? How can they have acted in such a dissimilar fashion? I think it is a combination of valuation and human behaviour that helps explain this incredible variation.
In the late 1800s, the United States experienced what Mark Twain described as the "Gilded Age" to become an economic powerhouse. During that time, the country emerged from the destruction of Civil War, rebuilt and industrialized. By 1900, optimism had overtaken devastation and the economy was booming. Stock prices more than reflected this sentiment with the Shiller P/E at 18.7. (The Shiller P/E is essentially a moving average of the price-to-earnings ratio over a 10-year period.) Given these expensive prices of public businesses at that time, it is little wonder that stock performance was so dismal over the next 21 years while the economy expanded. In 1921, the Shiller P/E had dropped to 5.2, reflecting little interest in owning publicly traded businesses. After all, stocks had gone nowhere for 21 years; why would you buy them with this long history of no return? Eventually, investors returned with the stock market ending in 1929 at bubble levels, with the Shiller P/E trading at more than 32.6. At that time, people were pouring money into the stocks, which eventually led to the 1929 crash and subsequent Great Depression. This pattern of optimism and pessimism repeated itself throughout the next 80 years.
I wrote in these pages in 2010 about how cheap stocks were and that the U.S. equity market was the place to be. Indeed it has, with the market appreciating over 125 per cent during the next eight years. As a result of the near-meltdown in the U.S. economy in 2007-08, most people regarded investing in U.S. stocks in the same way they would of contracting the Black Plague – avoid! And I also was around to see money pouring into the market in the late 1990s with wild abandon and no concern for paying the highest valuations, perhaps in history. The former led to huge gains, the latter to permanent capital destruction.
Returning to our key question, how can the stock market go nowhere for long intervals or down dramatically in value while the U.S. GDP growth remains relatively stable? Warren Buffett's answer is that investors behave in very human (emotional) ways. They get very excited in bull markets and make the recurring mistake in looking in the rear view mirror, regardless of overvaluation.
"When they look in the rear-view mirror, and see a lot of money having been made in the last few years, they plow in and push and push and push up prices," said Mr. Buffett in a 2001 speech. "And when they look in the rear-view mirror, and they see no money having been made, they say this is a lousy place to be."
Today, we find ourselves at expensive levels in the stock market after an eight-year bull market. In fact, currently the Shiller P/E is over 29, closing in on the 1929 high. Generally, more money has continued to pour into the stock market, large chunks flowing into indexes and ETFs. This rising market could go on for some time.
But, just as in the past, a point will be reached where the buyer of last resort will have committed his/her capital and just as in the past 116 years, we may be in for a long period of decline in prices.
Remember, the average investor buys recently posted great results – they buy stocks after great returns have already been achieved. Most don't participate in this capital appreciation.
So, caveat emptor.
Larry Sarbit is the chief executive and chief investment officer at Winnipeg-based Sarbit Advisory Services. Mr. Sarbit is a sub adviser on three funds for IA Clarington.