10 truths about the stock market

For more, read: Stomach-churning stock market sell-offs are common🎢, My favorite view of short-term stock market performance 📊, and A truth about bear markets and investing 🐻

At some point in your life, you’ve probably heard that the stock market generates an average annual return of about 10%.

While that may be true over the long term, the market rarely provides an average return in a given year.

Check out the chart below from Ben Carlson of Ritholtz Wealth Management. It plots the annual returns of the S&P 500 since 1926. If 10%-ish returns were normal, you’d see a solid horizontal line of dots just above the x-axis.

This chaotic jumble of points shows how difficult it is to predict what next year’s returns will be. This is true regardless of what is happening in the economy. Outside of the Great Depression and the global financial crisis, history’s major economic booms and busts are hard to make out.

The good news is that most of the dots are above the black line. In fact, stocks usually go up.

For more, read: Don’t expect average returns in the stock market this year 📊, Don’t be afraid of bear markets 🐻, and 2 A chart showing the volatile path of the stock market📉📈

A stock can only go down by 100%, but there is no limit to how many times that price can multiply.

Yes, we have seen some pretty bad sell-offs in the stock market. But it has multiplied many times. This is not guaranteed, but it is offered. From its low of 666 in March 2009, the S&P 500 is up more than 6x today.

For more, read: The incredible asymmetric reversal of the stock market 📈, There are more downsides for long-term investors 📈, and Warren Buffett reminds us that picking winning stocks is extraordinarily difficult 🤓

Any long-term move in a stock can ultimately be explained by the underlying company earningExpectations for earnings, and uncertainty about those expectations for earnings.

News about the economy or policy moves markets to the degree they are expected to influence earnings. Earnings (aka profits) are why you invest in companies.

For more, read: Earnings are the most important driver of stock prices💰, Peter Lynch made a remarkably prescient market observation in 1994 🎯, and Publicly traded companies are not charities 💸

There are several valuation methods that will help you estimate whether a stock or stock market is cheap or expensive. We won’t go through all of them here.

While valuation methods can tell you something about long-term returns, most tell you nothing about where prices will go over the next 12 months. In such a short period of time, expensive things may become more expensive and cheap things may become cheaper.

It’s worth noting that prices can be cheap or expensive for extended periods of time. In fact, some people would argue that ratings are not meaning-reversing.

For more, read: Stock market’s complex evolving relationship with valuations 📈, Use valuation metrics like the P/E ratio carefully ⚠️, and Goldman Sachs debunks one of the most persistent myths about investing in stocks 🤯

Investing in stocks is risky, so the returns are relatively high.

Even in the most favorable market conditions, there will always be something that keeps more risk-averse people on the sidelines. For more, see Yahoo Finance Morning Brief’s chart of the decade.

For more, read: Sorry, but uncertainty will always be high 😰 and Two recent examples were when uncertainty was low and confidence was high 🌈

A survey of market participants will generate a list of top risks, and ironically the most commonly cited risks are those that are already priced into the markets.

These are the risks that no one is talking about or few are worried will rock the markets when they surface.

For more, read: The most volatile risk for the stock market 📉, For markets, there is only one thing worse than bad news 📉📈, and Taking stock of corporate America’s ‘risk factors’⚠️

Just as most businesses don’t last forever, most stocks don’t last forever. The S&P 500 sees a lot of turnover (ie businesses that fail are dropped and businesses that come up are added).

In fact, it’s the addition of new and unexpected companies that has been driving much of the S&P 500’s returns over the past decade.

For more, read: 700+ Reasons Why S&P 500 Index Investing Isn’t Too ‘Passive’💡 and The makeup of the S&P 500 is constantly changing 🔀

While the performance of the US stock market is closely linked to the trajectory of the US economy, they are not the same thing.

The economy reflects all business conducted in the U.S. while the market reflects the performance of large companies—which typically have access to low-cost financing and are cheap on a scale of raw materials and labor.

Importantly, these large companies that make up the stock market do at least some of their business overseas where growth prospects may be better than in the US.

For more, read: Stock market is not an important means of economy 🌎, 4 key observations about the US stock market to remember 📊, and The ‘significant’ consumer shift that could define stock market performance in 2024 🔀

We may very well be on the verge of a terrible, multi-year bear market. Who knows?

However, the stock market is on the rise.

It makes sense if you think about it. There are many people who want things to be good, not bad. And that demand encourages entrepreneurs and businesses to develop better goods and services.

And the winners of this process are bigger as the revenue increases. Some are big enough to be listed on the stock market. As income increases, So earn.

And earnings drive stock prices.

This post was originally published on TKer.co on October 15, 2021.

¹ “Stock market” is a generic term commonly used to refer to the major US indices: the Dow Jones Industrial Average, the S&P 500, and the Nasdaq. When I refer to “stocks,” I’m usually referring to the S&P 500. When discussing specific statistics, I will be clear about what I am talking about.