Unexciting expectations.

The stock market is a puzzle to most people. It zigs when everyone expects it to zag. It goes up on a bad unemployment report one day, then down when a report shows the economy is booming the next. It can leave us frustrated and angry on such occasions.

Although I agree it’s a mystery in the short term, it’s much less of a puzzle over the long term. At any point in time, it’s possible to provide a reasonable range of returns for the next 5 or 10 years. The market doesn’t end at a precise point over that time frame, but it does follow a logical path.

The market’s underlying logic is based on fundamentals. They include: 1) profits, 2) growth, 3) dividends and 4) how much people are willing to pay for those three. The first 3 are straightforward; the third is erratic over the short run, but tends to revert to the mean over the long haul.

No crystal ball needed. No eye of newt, or rat tail. Just an understanding of the underlying logic and the discipline to realize that’s where things will head over time.

What does my “crystal ball” show for market returns over the next 5 to 10 years? A pretty unexciting picture. Over the next 5 years, I expect returns of -4% to 11%, with an average tendency of 3%. See, unexciting. Over the next 10 years, it looks like 2% to 10% annualized returns with an average of 6%. Assuming inflation in the 3% range, that leaves 0% to 3% real, annualized returns over the next 5 to 10 years. Probably a lot less than most people are expecting or planning.

The path to that range and those averages is likely to be much more “exciting.” If anything was learned over the last 2 1/2 years, it’s that a boring long term path may prove terrifyingly exciting over the short run.

The market peaked in October 2007, plunged 57%, then climbed 79% to today. That’s a 23% decline from fall 2007, and an annualized loss of 10% a year. Our path going forward may prove similarly breath-taking.

How do you avoid such “excitement”? Don’t invest in the stock market. But, beware that inflation and defaults may make cash and bonds just as terrifying.

Is there any way to do better? Yes, but it means being more selective than buying “the market.” Over almost any time period, some stocks do well. Finding them isn’t an easy task, but it can be done. Wal-Mart and Johnson & Johnson, which I held for clients and myself during the downturn, did quite well.

This doesn’t eliminate risk, or volatility. That’s just part of life (and especially investing). But, better long term returns are possible. They’re unlikely to shoot out the lights, but they can put you in a much better position when the next real bull market begins.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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The stock market is all about expectations

The stock market has rallied strongly since March. Why has the market rebounded in the face of weak economic data? The reason: because the market is all about expectations.

The stock market is a reflection of investor expectations about future economic profits. When investors expect economic conditions to improve and companies to make growing profits, the stock market tends to go up.

Recent economic reports do not show a growing economy, but they do show that the economy is declining less quickly. Why is that a good thing? Think about an airplane in a nosedive. Before it starts to climb again, it’s rate of descent needs to slow. Then it levels off before it climbs. The rate of descent must get less bad before leveling or climbing can occur. Same with the economy.

The market has rallied since March not because economic data or profits have grown, but because things are getting bad less quickly. If it turns out that profits level off at a low level, keep declining slowly, or climb at a slower rate than people expect, the market will decline. In other words, the market will decline if economic growth and company profits don’t meet or exceed investors’ current expectations.

How likely is it that economic growth and company profits will miss, meet or exceed expectations? I have no idea, but in the short run that’s the $64,000 question. If you invest long term, pick good investments, and pay the right price, you don’t need to guess this outcome.

But, it’s an interesting question to ask. Do you expect strong economic growth over the next year? Do you think consumers are ready to start spending again despite 10%+ unemployment? Do you think recent government efforts to spur economic growth will work? Do you think company profitability will rebound by around 50% like the market is expecting?

After listening to conference calls over the last 3 weeks, I have to admit to having an opinion (for what that’s worth). Almost every company I’ve listened to has beat profit expectations by cutting costs and missed expectations in terms of sales. In other words, they are missing expectations for selling products, but meeting profit expectations by firing people and not spending for future growth. That doesn’t sound sustainable to me.

The market seems to be basking in the glow of potential, not actual growth. If that growth turns out to be ephemeral, look out below!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.