Understanding the Stock Market
The attention my 100 Years of Stock Market History post has received has made it clear to me that, because of the current volatility in the stock market, there is great interest in trying to get a broader perspective on the stock market. I think people are trying to understand the stock market (I know I am). To really understand the stock market, just looking at a graph of 100 years of Dow Jones history is not sufficient; we need to analyze it; we need to figure out “what makes the stock market tick.”
The objective of my Stock Market Analysis Model is to gain a better understanding of the performance of the Dow Jones and S&P 500 stock market indexes over time. The presumption is that earnings, dividends, and price/earnings ratios are the primary levers that drive performance. The model allows us to approximate the contribution of each of those components for any given period in the past.
Ten Questions the Stock Market Analysis Model Will Help You Answer
Here are some of the many questions this model can help us answer:
1. What was the DJIA’s (Dow Jones Industrial Average) average return between 1929 and 2002 (or for any other period)?
2. How much do dividends matter?
3. How can I tell if the stock market is undervalued (cheap) or overvalued (expensive)? What is the impact of stock market valuation (e.g., price/earnings ratio)?
4. What was the relative contribution of earnings, dividends and price/earnings ratio increase/decrease to the stock market’s performance between 1994 and 1999 (or for any other period)?
5. What is the long-term average performance (annual return) of the stock market?
6. What is the Dow’s earnings history? What's the average long-term earnings growth rate?
7. What were the best/worst 10 or 20 years in stock market history?
8. What is the cheapest the market has ever been? Where would the Dow be now if it were valued that cheaply?
9. Does it matter when I buy? If so, when is a good time to buy, and when is not so good?
10. After a market peak, what is the longest it has taken to regain that level? (I call these long flat periods “periods of disinterest.”)
Al's Stock Market Analysis Model (click to enlarge)
Analyzing the Bull Market From 1994 to 1999
The screenshot above (click to enlarge) shows that the Dow returned 26.9% per year between year-end 1994 and year-end 1999. (The annual returns ranged from a high of 37% in 1995 to a low of “only” 18% in 1998.) If you had invested $25,000 at year-end 1994, and re-invested dividends, by the end of 1999 your investment would have more than tripled -- to more than $80,000. It was definitely what I call a "period of excitement."
(Note: in my current methodology, I normalize earnings for each year by averaging those earnings with the five prior years and the five following years. The normalized price earnings ratio --NPE-- is the ratio of closing price to normalized earnings. For a more detailed discussion, see About Normalized Earnings and P/E Ratios.) Now, the not so good news. The biggest contributor to the returns was an increase in price/earnings ratios. In fact, 14.4% of the 26.9% annual return was due to an increase in the NPE; it increased from 15.3 to 28.3. Normalized earnings grew at 10.2% -- considerably higher than the long-term average of around 6%. However, a contributor to this increase was, believe it or not, earnings associated with appreciated stock holdings. Thus, we had the makings of a perpetual motion machine -- increasing prices increased earnings, which increased prices, which.... Finally, dividends contributed less and less as the market went higher.
At the end of this period, the dividend yield was at an all-time low of 1.5% and the NPE was an all-time high 28.3. If you had known all this in 1999, might you have done something different from what you actually did at the time? ….. Yeah, me too.
Here's Al's Stock Market Analysis Model (see the "Historical Analysis" and "Dow Data" tabs).
I will add some additional features (and tabs), and continue the analysis in a future post. Meanwhile, if you discover anything interesting about the stock market by playing with the model, or find novel uses for it, please let me know.
NOTE: If you have trouble downloading the spreadsheet, see this post.
Related Materials:The Extraordinary Impact of Price/Earnings Ratios: The next post in this series.
The Crisis: A Contributing Factor: Discusses, among other things, the impact of investors not investing based on valuations.
The following describe similar methodologies for approaching stock market valuations. From a “big picture” point of view, they arrive at similar conclusions.
Bogle on Mutual Funds, by John Bogle: Analysis is based on S&P 500; uses dividends rather than earnings.
The Likely Range of Market Returns in the Coming Decade, by John Hussman (February, 2005): Analysis is based on S&P 500; normalizes earnings by using “peak earnings.” (Note: More technical than the others.)
Irrational Exuberance, by Robert Shiller: Analysis is based on S&P 500; normalizes using prior 10 years’ earnings; adjusts for inflation.
Last updated 10/19/2010