The stock market rarely produces average returns
We read a lot at Vestbridge Advisors, Inc. and this article is worthy of sharing. This is a reprint from the Yahoo Finance 10/11/2022 Morning Brief.
Wall Street firms have begun publishing their 2023 forecasts for the S&P 500.
Targets published by seven top equity strategists range from 3,800 to 4,200, implying returns of 4% to 15% from current levels.
We’ll only know how accurate these calls are in hindsight. We do, however, know that last year’s 2022 forecasts have proven very inaccurate so far.
As of Dec. 5, 2021, 14 strategists followed by TKer.co had 2022 year-end S&P 500 targets ranging from 4,400 to 5,300. At the time, the implied one-year returns ranged from -3% to +17%.
There’s a lot to be said about making these short-term forecasts.
One thing is that they often gravitate around a midpoint expectation for about 8% to 10% returns.
And why not? Historically, the average annual return on the S&P is about 8% to 10%.
Unfortunately, 8% to 10% returns aren’t as common as you might think. Check out these two charts published last week from A Wealth of Common Sense. They chart the annual returns of the S&P 500 since 1977.
As you can see, 8% to 10% returns are not common at all. This is an important truth about the stock market.
The 8% to 10% average comes from many years of outsized returns, many years of weak or negative returns, and a few years of average returns.
On this matter, I often think about this quote legendary investor Peter Lynch gave at a speech on October 7, 1994:
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs… Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go. So, the market ought to double in the next eight or nine years. They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That’s all there is to it.
When he says “the market,” Lynch is referring the Dow Jones Industrial Average, which closed at 3,797 on the day he gave the talk. If you compound that by an 8% growth rate over 28 years, which would get you to present day, then you get 32,757. The Dow closed Monday at 29,203, which is pretty darn close.
If you did this exercise with the S&P 500, which closed at 455 on the day of Lynch’s talk, then you’d get 3,925 assuming an 8% compound annual growth rate. The S&P closed Monday at 3,612.
Again, if you look at the charts above, you don’t see many years with 8% returns. But over time, you get an average return of nearly 8%.
While your long-term investment plan may assume average returns in the stock market, it certainly shouldn’t assume average returns every year.