Background – Our Biases at Play
We’re all guilty of it. We look at a graph and instinctively attempt to extrapolate into a future that we cannot possibly predict, using flawed logic and a number of confounding behavioural biases.
Ask most normal people to look at a chart of the S&P 500 since 1926 and a few thoughts on the past and the future that spring to mind are, inevitably, along the lines of:
- (PAST): Damn. I wish I’d been alive in 1926 (or even 1950… let’s avoid the 1929 crash!) and put all of my savings into this.
- (FUTURE): But now, it looks very precarious. Surely it will crash? How can it possibly stay at these highs, or even make new highs going forward? We’re all doomed.
This tendency to negative future speculation reminds me of the popular UK Television drama “Casualty“. Part of the fun, as a viewer, was to guess which of the new characters introduced in opening scenes would end up taking a fall. Would it be the middle aged chap straining in the gym, the lady tottering at the top of an unsecured ladder, or the apparently perfectly healthy person doing something innocuous? Satisfyingly, in this case, somebody usually did end up, as we had expected, in casualty; our biases confirmed!
We love to play this game, and we tend to be pessimistic, given the evolutionary preference for “flight” over “fight”, driven by the need to “live to fight another day”.
The need for Logic over Instinct
Let’s look at the chart again, without the red arrow:
What this is showing is the Price of the S&P 500 index over a very long period, indeed. One driver behind the increase in Price is, therefore, the compounding effect of 90 years of inflation. We won’t be deflating back to 1926 prices for anything, any time soon, hence we have reason #1 for being a little more comfortable with these “highs” persisting.
However, there’s a more important driver at play that supports higher stock prices: growth in company earnings.
As a result of new products and services and efficient ways of working being brought to market over the last 90 years by companies within the S&P 500, we have reason #2 for paying higher prices for the stock of those companies.
This is neatly encapsulated in the measure of “expensiveness” of equities known as P/E (Price/Earnings). Put simply, we should be willing to pay a higher “P” for a higher “E”.
If we look now at the P/E ratio for the S&P 500 over the same period, we see a reassuring consistency in this ratio. P/E has bounced around between 15-20 on average over the last 90 years i.e. investors have been prepared to pay around a 15-20x multiple of the previous 12 months’ of company earnings, in the average S&P 500 stock price.
P/E, unfashionably, does not “go to the moon”, but reflects what all market participants view as a “reasonable” multiple to pay. The one enormous P/E spike on display (from May 2009, when P/E reached a value of 124x due to the depressed earnings of the “Great Recession”) we can view as the exception that proves the rule; a P/E multiple which quickly mean reverted back to the normal “15-20x” range.
And where are we now? A bit on the “expensive” side, but certainly not as precariously so as the “Price” chart, in isolation, would have us believe.
Conclusion
I’ve come across the bias which results in the “red downwards arrow” in many conversations with clients, friends and family and so I do think it’s something very fundamental and therefore worth addressing.
Persisting in the hope of a return to what looks like a more “normal” Price level for the S&P 500 is not going to be a profitable strategy.
Much better, then, to stay invested. A bet on company earnings growing in the future (hence, justifying higher stock prices) is fundamentally a bet on human ingenuity continuing, and that’s the one prediction I’m happy to make.
Michael Davidson is a Singapore-trained and qualified Financial Adviser with Global Financial Consultants Pte Ltd providing specialist financial advice and portfolio management services to international and local professionals in Singapore.
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*Please note that Michael Davidson is not a tax specialist or accountant and that none of the content outlined here should be taken as personal advice. You should consult your tax specialist and financial adviser to review your current financial situation and futures goals to consider whether this strategy is appropriate for you. I expressly disclaim all and any liability to any person or organisation, in respect of anything, and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or in part, upon the whole or any part of the contents of this article.
