This is my last regularly scheduled column for Morningstar. I am retiring from the company for the best of all possible reasons. My health is fine, and my bosses would prefer that I stay on the job. However, I can afford to spend my time otherwise, should I wish. Recently, I have realized that I do wish.
This is a tale of triumph. By which, I do not mean my career. To be sure, that has been a happy surprise, as I entered the field with little expectation after dropping out of an English Ph.D. program. (Later, I did receive formal training in my new occupation, first achieving the chartered financial analyst designation and then earning an MBA degree.) But this article is not about me. It’s about the splendor of the US stock market.
I write those words with genuine and heartfelt appreciation, as I was late to learn about the blessing of equities. My family did not invest. My mother’s relatives worked as teachers and librarians, supplementing their pensions with bank savings. My father’s side, for the most part, consisted of high school graduates whose long-term financial plans were to make it to the next year.
Consequently, I was raised to regard stock purchases as gambling. Win some, lose some. It was only as an adult that I learned that the greatest benefit of stocks came not when they were shuffled but instead merely from being held. Unlike with the casino’s patrons, the odds favor stock market participants.
The Rising Tide of Corporate Earnings
The reason for the stock market’s success is simple: Companies generate profits, and over time, those earnings increase more often than they fall. For example, I began working at Morningstar in February 1988. The chart below shows two versions of the change in earnings of the companies in the S&P 500 since that date: 1) nominal, which is the customary method of reporting financial results, and 2) real, which is the relevant measure for investors, as it removes the effect of inflation. The initial value of each measure is 100.
Very nice. Better yet, that earnings growth was merely the foundation, as most companies issue dividends that improve a stock’s total return. Again, I will use my personal experience as an example. Shortly after arriving at Morningstar, I placed $1,300 into a US equity fund called Nicholas II NCTWX. When doing so, I opted to reinvest the fund’s distributions, to buy additional shares.
From Earnings to Total Returns
The effect of those dividends, along with the subsequent increase in equity valuations—the stock market’s price/earnings ratio has since doubled—has been dramatic. The next exhibit retains the previous chart’s data, but this time it translates my $1,300 investment into its initial value of 100. The illustration also plots: 1) the nominal and real total returns for Nicholas II and 2) the outcomes for the fund I should have selected, Vanguard 500 Index VFINX.
There are two ways of regarding those results. One is that I should have read Jack Bogle’s advice before buying my first fund! After all, my choice forfeited one third of the investment’s potential profits. That could be cause for regret.
However, that is not how I view the matter. To start, Nicholas II’s shortfall was not caused solely by its higher costs. It also fished in the wrong pond. Most of its companies were not large enough to be included in the S&P 500. Over time, suggested the academic research, those smaller companies should outgain the blue chips. Over those 37-plus years, they have not done so. C’est la vie.
The larger and much happier point is the height of that yellow line! My portfolio is now worth $40,820, as opposed to its piddling $1,300 stake. True, that figure must be discounted to incorporate the greater power of 1988’s dollars. (The greenback better have purchased more items back then, because my starting Morningstar salary was $18,000.) Even so, who am I to complain?
The Wall of Worry
The stock market’s enormous gain is only half the story. The surprising, amusing, and often bewildering corollary is that so few people believed along the way. After all, US companies performed as expected, by growing their businesses and paying dividends. Even if their price/earnings multiples had remained flat rather than doubling, my investment would be worth $20,420 nominally and $7,495 in real terms.
Yet, there was so much disbelief during the journey. Among the first issues of Barron’s that I read featured a gentleman named Bob Prechter, who predicted that the Dow Jones Industrial Average would soon drop to 400. At the time, the DJIA was at 2,000. It’s now just north of 44,000.
Prechter’s claim was extreme, but his sentiment was typical. The arguments against stocks were legion. After 12 years of GOP prosperity, a Democrat was in the White House. Equity investors were irrationally exuberant. The CAPE ratio showed that stocks were historically expensive. The global economy’s “New Normal” after the 2008 global financial crisis would depress equity prices. The Federal Reserve had propped up the marketplace through its policy of quantitative easing. Beware when it removed the training wheels!
That is my salient career memory: the perpetual belief that equity investors had missed the party. Yet, they never have. For example, 25 years after joining Morningstar, I finally bought some Berkshire Hathaway BRK.B shares in 2013. Too late? Not at all. The company was worth $150 billion at the time of my purchase. It now holds more than twice that amount in cash alone. Its overall value is a cool $1 trillion.
Looking Forward
Of course, I do not expect equities to perform so spectacularly over the next 37 years. Their price/earnings ratio is highly unlikely to double again, and the economic backdrop may not be so rosy. On the other hand, one aspect of the US economy will almost certainly persist: the advantage to capital. For a long, long time in this nation, business owners have grown their wealth faster than have business workers. I see no indication that this condition will change.
That is the “farewell” from this article’s headline. But it also contained the phrase “for now.” That reflects an agreement I have made with the company. I will continue to submit articles to Morningstar when a topic interests me. In exchange, the company will [crosses fingers] permit me to keep my email address, which is john.rekenthaler@morningstar.com. Do keep in touch.
The author or authors do own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
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