Thursday, June 14, 2012

There Should Be No Profit in the Stock Market

If you were like me when you were younger, you had questions or observations about economics, philosophy, finance, etc., that were so simple that you PRESUMED you were wrong.  Your logic was too simple, it made too much sense, and the real world around you (at that time) was providing evidence to the contrary of your observation.

However, I've studied economics long enough, lived long enough, and thought all my founding and consequential theories through to the point I've realized that one of my innocent observations back when I was in college was actually correct, and no, my logic was not flawed.  And that observation was:

There should be no profit in the stock market. 

I came to this observation when I was thinking about "market efficiency" - the concept that a market would price in all known data and information into the price of a stock, thereby reflecting its true value. If this is true, then prices would be bid up or down to the point the stock would have a "fair" value, leaving no room for profit or arbitrage. 

What triggered this original observation was the "investment philosophy" that over time the S&P 500 has historically provided 10-12% annualized rates of return (depending on whether you account for dividends or not).  I found that odd because 10-12% per year is a sizable premium over inflation. If markets were truly efficient, that margin of return would attract more and more money, flooding the market until the real rate of return was 0%.  This would initially result in prices being driven up (becoming a self-fulfilling prophecy as those increases in prices would result in higher returns), but inevitably stock prices would reach an "equilibrium" point where the dividends and profits of a firm would attract no more money and prices would stabilize resulting in no future capital gains. 

I originally theorized why the market kept going up for reasons similar to why we have a underfunded pension crisis - poor assumptions made on the part of actuaries.  Specifically, the market was failing to account for population growth and longevity of people.  So when Henry Ford started Ford, investors thought "we can sell these things to all 50 million Americans" failing to look into the future where the market in 100 years would NOT be 300 million Americans, but 3 billion people in 1st and 2nd world economies.  That growth was never factored into prices back then.

I also theorized that the S&P 500 index is always "fresh."  Meaning that it is a self-selecting and de-selecting index, getting rid of companies that either fail and are obsoleted through technological advancements, while bringing in the new, up-and-coming companies.  This "survival of the fittest" aspect of the S&P 500 means companies that grow the most to become the largest and most "successful" companies in the US ensure positive rates of return.  And not just positive, but these new companies and the technologies they bring into the world capitalize on larger and entirely new markets made from whole cloth (Apple for example with its electronic doo-daddery). 

However, while this explains why there has been (historically) considerably higher-than-inflation rates of return, it still doesn't debunk my theory there should be no profit.  All it shows is that the market failed to be efficient and underestimated technological advances and population growth.

There is, however, a very interesting chart that speaks to this.  Robert Shiller has created, among many other charts, this one which I find very telling:


It is the 10 year average PE ratio vs. their 20 year annualized returns for 5 separate periods or "vintages" throughout the history of the S&P 500.  What it shows is that people are actually OVERLY OPTIMISTIC when it comes to their expected rate of return.  Companies with very high PE ratios provide lower returns than companies with very low PE ratios, never delivering the profits they were promising. 

This is counter to what I thought was the case.  If people were underestimating the market, then higher PE ratio companies would result in higher returns.  But here, it shows we are overestimating the market. Admittedly, following the "survival of the fittest" aspect of the S&P 500 Index, a lot of those dots in that chart that had high PE's are no longer with us today and thus their statistical representation is moot.  The S&P 500 jettisoned them once they got too small or went bankrupt.  This, however, does not change the fact people's psychologies remain overly-optimistic.

Sadly, this is as far as my thinking and statistics have gotten me.  I know intuitively that if the stock market were TRULY efficient, it would reach an equilibrium point in terms of pricing resulting in 0% capital gains (which, consequently, would DESTROY the entire US retirement industry).  However, my best guess would be the answer lies somewhere in the market failing to account for population growth, underestimating technological advances, or just plain failing to account for increase in disposable income (though that factor will soon be going away).

Any ideas lieutenants?

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