Thursday, August 21, 2014

200 years of the stock market (actually only 189)

I'm a glutton for historical numbers, especially pertaining to stocks. Awhile back I came across a post that had a histogram of the overall stock market returns since 1825. More on the numbers shortly...

Prior to reading that post, I was already aware that, from the end of 1814 to the end of 1925, the U.S. stock market experienced compound annual growth of about 5.8% per year. This is based on data put together by Robert Shiller, and this measure used a price-weighted index, which has many flaws but is the way that most of the indices are measured today.

To use a different time period and a different yardstick, Buffett once mentioned that the Dow went from 66 to 11,219 during the 100-year period during the 20th century, which is a 5.3% CAGR. Adding dividends to that figure, and shareholders might have realized 7-8% annually or so.

To use a third historical time period, I noticed in Buffett's annual shareholder letter that the S&P 500 has averaged 9.8% annually over the last 49 years (since he took over at Berkshire).

I think the last 200 years provides pretty good evidence that over the very long term, I feel comfortable expecting the market to average somewhere between 6% and 9% annually including dividends (if I had to guess, I'd be closer to 6 than 9).

Take a look at the last 189 years of general stock prices:

Some anecdotes I find it interesting to observe the results of 189 years between 1825 and 2013:
  • The market had 134 positive years and 55 negative years (the market was up 71% of the time)
  • 44% of the time the market finished the year between 0% and +20%
  • 60% of the time the market finished the year between -10% and +20%
  • Only 14% of the time (26 out of 189 years) did the market finish worse than -10%
  • Only a mere 4.8% of the time (fewer than 1 in 20 years) did the market finish worse than -20%
So to put it another way (using the 189 years between 1825 and 2013 as our sample space), there is an 86% chance that the market finishes the year better than -10%. There is a 95% chance the market ends higher than -20%. And as I mentioned above, there is a 71% chance that the market ends any given year in positive territory.

One last observation: the market was 5 times more likely to be up 20% or more in a year (50 out of 189) than down 20% or more in a year (9 out of 189)!

Now, lest my readers suspect me of predicting further gains... let me make it clear that I'm not trying to make a case that I think the market won't or can't go down, or even go down a lot. On the contrary, after 5 years in a row of not just positive years, but exceedingly above average gains, we are certainly "due" for a down year. After all, the market finished the year down 29% of the time over the past 189 years, or about once every 3 or 4 years.

I just think that it's difficult to predict when the down year--and certainly when the next big crash will come. Make no mistake, the market will crash from time to time. The economy will suffer another credit crisis. It's just difficult to know when. The stock market certainly will go through another 10% correction in the near future. It will likely go through a 20% correction in the near future. There have been 12 of those corrections since the mid-'50s when the S&P 500 index was instituted, or about one every 5 years. We haven't had one since early 2009 so we're due for one of those as well.

Although certain to happen again, crashes are rare. The 2008 type scenarios are extremely rare. Only 3 times since 1825 did the market finish a calendar year down 30% or worse. That's about once every 63 years. People tend to overestimate the probability of a market crash when one recently occurred. The storm clouds of 2008 are in the rearview mirror, but they are still visible and the effects of the storm still evident.

They key thing to remember is that when you own a stock, you own a piece of a business. Graham's logic is as simple as it is timeless. It really helps to remember that you don't own numbers that bounce around on a screen, you own a business that has assets, cash flows, employees, products, customers, etc. Just like the owner of a stable, cash-producing duplex located in a quality part of town isn't frantically checking economic numbers or general stock index prices on a daily or weekly basis, nor should the owner of a durable business that produces predictable cash flow – purchased at an attractive price – be concerned about the day-to-day fluctuations in the quoted price of his share of the company.

As Munger said, sometimes the tide will be with us and sometimes the tide will be against us, but the best thing to do is to just continue to swim as competently as we can. Although ocean tides are much easier to predict than the direction of the stock market, I still think it's best to focus on swimming as opposed to anticipating the changes in the tides.

-- John Huber, Base Hit Investing

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