The stock market rises or falls based on a few key variables.
Firstly, there are earnings, the amount of profit that companies in aggregate report for the quarter or the year. Earnings grow or fall over time, with some operational leverage relative to the economy. This means that during strong economic growth, corporate earnings usually go up faster than GDP growth, and during a sluggish economy, corporate earnings usually fall harder.
Secondly, there are dividends. This component historically provided 3-6% of annual returns or more. Currently the dividend yield of the S&P 500 is lower than any time except for 2000 because stock valuations are rather high and corporations are relying more on stock buybacks than dividends these days, so the average dividend yield is less than 1.8%. This has been a relatively small contributor to stock returns in recent years.
Thirdly, there are valuation changes. If a company has a price-to-earnings ratio of 15, it means the stock price is fifteen times higher than its annual earnings. If during the next year, the market bids up the price to a price-to-earnings ratio of 20 while earnings stay flat, the stock price could go up 33% even without changes in the underlying earnings.
The same is true for the downside.
This third option is what happened in 2019. After strong corporate earnings growth in 2018, corporate earnings were essentially flat in 2019.
The final quarter isn’t in yet, but from the data currently available, 2019 was a flat-to-down year for corporate earnings in the first three quarters, with a possible uptick in the fourth quarter. Consensus analyst estimates are for the year as a whole to be flat.
And yet, the S&P 500 average price-to-earnings ratio increased from less than 20 to over 24, and the S&P 500 provided very strong returns for the year. Positive sentiment for stocks became very bullish by the end of the year.
A good visual example of this is Apple stock, which is currently the biggest stock in the C Fund. The C Fund has 500 companies in it, but Apple alone accounts for 4-5% of the fund, with Microsoft accounting for another 4-5% of it, because they are so big. Together, these two companies account for about 9% of the 500-company C Fund.
With a market capitalization of almost $1.3 trillion, Apple had a truly stunning year, with 83% price gains. The stock had a sharp sell-off at the end of 2018 as investors were concerned about multiple factors, including potential Chinese retaliation in the trade dispute and tight Federal Reserve monetary policy, but all through 2019 it rebounded strongly to new all-time highs as Federal Reserve monetary policy loosened and the international trade dispute eased.
In this chart below, the black line represents Apple’s stock price, which currently includes a price-to-earnings ratio of 24. The blue and orange lines represent what the price would be if the stock were at its historical average price-to-earnings ratio of about 15:
Apple’s earnings were flat in 2019, with zero growth. Their phone sales were sluggish, which was partially offset by an increase in service revenue. But their stock price absolutely skyrocketed this year, especially during these past few months.
Investors should exercise caution, either with a diversified portfolio, or sticking to their investment process, or by consulting a financial professional. We could very well have another strong stock market year in 2020, but on the other hand, valuations are historically high, and the stock market has generally outpaced underlying economic fundamentals and corporate profits lately.
It is hard to say whether economic fundamentals will start to catch up to stock prices in 2020, or if stock prices might catch down to underlying fundamentals, which is why maintaining a degree of diversification is useful.
See also, Understanding TSP Withdrawals