The more the market drops, the more attractive stocks become for long-term investors. Why? Because the more the market drops, the cheaper the stocks become in relation to likely long-term corporate cash flows. Importantly, this is true even if the economic news over the next couple of years is so bad that S&P 500 earnings go to zero (which would be completely unprecedented).
Despite all the talk about stocks being worth the “present value of future cash flows,” the stock market usually trades as though the only thing that matters are this year‘s or next year‘s cash flows. When this year’s cash flows head into the tank, as they have over the past year, stocks go with them. And when this year’s cash flows soar, as they did from 2003-2007, stocks skyrocket.
Given the tendency for earnings (and dividends) to grow at a relatively steady 6% over the long-term, this market behaviour is senseless. But the short-term investor’s loss is the long-term investor’s gain.
Fund manager John Hussman illustrates this in this excerpt from his weekly letter. We add some more thoughts below:
[I]f the long-term record is clear on one point, it is that most of the fluctuation in the stock market is due to changes in risk-premiums, not major variations in the long-term stream of cash flows delivered by U.S. corporations over time. Just as driving down the price of a bond raises the long-term yield to maturity on that bond, stock market plunges also increase the long-term return that stocks are priced to deliver. This was true even in the Great Depression.
Despite this regularity, many investors believe that a decline in stock prices must reflect expectations for a similar decline in long-term earnings power. Worse they may believe that short-term declines in earnings will inevitably lead to a similar decline in stock prices. The fact is that stocks are not simply a claim on next quarter’s earnings, and it is absurd to value them on that basis. Stocks are a claim on a very, very long-term stream of future cash flows. The main source of variation in the stock market is not variation in those long-term cash flows, but variation in the long-term rate of return used to discount them. Even several years of bad earnings does very little to the fundamental value of stocks that have sustainable business models and reasonable balance sheets.
Take S&P 500 earnings back even to the Great Depression and you’ll find that despite enormous volatility in year-to-year earnings, the growth rate from peak-to-peak across market cycles has been remarkably steady at about 6% annualized. Alternatively, you can approach the S&P 500 as the discounted value of a very long-term stream of future dividends (blue), and you’ll find that the actual index (red) has reliably traded around that value for over a century.
The chart above is based on the actual dividends at each point in time, including during the Great Depression. The blue valuation line declines on the basis of this methodology because actual dividends were cut during the Depression, and the model gives full weight to that cut.
As with earnings, however, the stream of income that is realised over time tends to be far better behaved than year-to-year fluctuations might suggest. The value of that stream is particularly well behaved. The chart below shows the price that an investor would have paid for the S&P 500 in order for the actual, realised, subsequent dividends paid on the index to deliver a long-term total return of 10% annually (the current valuation assumes a growth rate of about 6% on normalized dividends from here).
The main lesson of the above charts is that the long-term fundamental value of stocks is far smoother than either prices, earnings or even dividends. The other lesson is that stock prices fell in the late 1920’s and over the past year – as well as the past decade – because they deserved to fall.
After over a decade of strenuous overvaluation, stocks are now undervalued. Not ridiculously cheap, but undervalued and likely to deliver satisfactory long-term returns to even passive investors. It’s certainly possible that stock prices could fall further by the time that the current market downturn is over, but to some extent, the profound depth of the recent selloff has given value investors something of a “freebie.”
Let’s put some more numbers on that.
For example, let’s assume a company will earn $100 a year for the next 100 years. If we discount those cash flows at 10% a year, they are worth about $1,000. If you zero out the first three years–by assuming the company earns nothing until year four–the cash flows are worth $750. This is a sharp fall in value, but it’s not a total collapse.
That’s a no-growth scenario, however. If, instead, you assume the company starts by earning $100 and then grows earnings 6% per year (the same long-term growth rate as the S&P 500), the discounted value of 100 years of cash flows is about $2,400. If you zero out the first three years, the discounted value drops to about $2,200, or about 10% less.
So what will the US stock market be worth if S&P 500 earnings go to zero for three years? Unless the long-term earnings growth rate of 6% has changed, it will be worth about 900 (or, at worst, if earnings really do go to zero for three years, 10% less).
(Yes, if the US economy is so screwed that corporate earnings over the next century grow at, say, 2%, instead of 6%, the S&P 500 is worth a heck of a lot less than 900. But earnings grew 6% in the 20th Century even with the Great Depression, so that would be a pretty profound assumption).