In the long term, its only earnings
Over the long term, the single most fundamental driver of price is earnings, and only earnings.
Over very long periods, the contribution to total return from changes in PE is negligible and the contribution from dividend yield is relatively small. Therefore, long-term returns will be roughly equal to earnings growth.
This results in the most fundamental picture of the behaviour of markets. This graph shows the long-term price performance of the United States market, represented by the Standard & Poor’s S&P 500 index, since 1871.
Great Investment Pictures: Price follows earnings
The United States market – price and earnings (S&P 500 index)
Data source: Robert Shiller, Yale
Price has tracked earnings closely over the long term. Phases of poor performance and bear markets have tended to result from price running too far ahead of earnings and vice versa. The price movements around long-term earnings are secondary effects, attributable to shorter-term changes in rating.
The picture shows that the United States market’s price lagged earnings from 1974, and then began to accelerate from 1982, producing an almost two-decade long bull run, overshooting earnings from 1996 until its peak in 2000. The market price then followed the decline and subsequent recovery in earnings, with the gap almost closing, although earnings have since fallen.
Incidentally, over the long term, the United States market has exhibited two distinct phases. In the first phase, from 1871 to 1941, its average price appreciation was quite uninspiring at slightly less than 1.0% p.a., with the market rising by only 100% over these 70 years. In the next 66 years to the end of 2008, the market rose by a dramatically higher 7.1% p.a., appreciating by 10 000% over this period.
The fact that price follows earnings over the long term is universally true for all markets, including the South African market, as shown in the next graph of the ALSI and its earnings since 1960.
The South African market – price and earnings (ALSI index)
Again, price has tracked earnings closely and phases of strong bull and bear markets have tended to result from price deviating too strongly from the trend in earnings.
In the words of Warren Buffett, “It is an inescapable fact that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.” Obviously, the longer this growth persists, the better. Very high growth rates, however, are difficult to sustain, so there is often a trade-off between the level of growth and its duration. It is also an inescapable fact that most long-term earnings forecasts breach this principle.
The first principle of long-term investing is therefore to select shares that will show good earnings growth over your investment horizon.
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Great Investment Picture #2