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The Hidden Dangers of Extrapolating Stock Market Performance

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Financial planners often rely on extrapolation, assuming that past trends will continue into the future. However, this can be a risky approach, especially during times of overvaluation. While stocks have historically outperformed inflation with a 6% annualized return, it is crucial to remember that this may not hold true for every client.

Consider the case of Japan’s stock market, which has been below its all-time high for 34 years. Many financial advisers dismiss this as an exception rather than a rule. However, they are surprised to discover that the U.S. stock market has also experienced long periods of below-average performance.

In fact, over the past 56 years since September 1967, the U.S. stock market has been a below-average performer. This is a little-known fact, even though the numbers speak for themselves.

According to data from Edward McQuarrie, a professor at California’s Santa Clara University, the stock market has historically delivered an average real total return of 6.1% annualized since 1793. This is represented by the red line in the chart below.

In contrast, the S&P 500’s real total return since September 1967 has been slightly lower at 5.7% annualized, as shown by the green line. While the difference may appear insignificant, it can have a significant impact on investment outcomes.

To illustrate this, let’s consider a $100,000 investment made in stocks in September 1967. If this investment had grown at the historically higher rate of 6.1% annually, it would be worth $2.8 million today in constant dollars. However, if the same amount had been invested in the S&P 500, it would only be worth $2.3 million – a difference of half a million dollars.

This example underscores the importance of avoiding blind extrapolation and considering the current market conditions. Financial planners must take a more nuanced approach, tailored to each client’s unique circumstances and the prevailing market environment.

Ultimately, by acknowledging the limitations of blindly assuming past performance, planners can better guide their clients towards realistic investment strategies that align with their long-term financial goals.

Introduction

Historical Performance

By analyzing a chart, we can see that an investment made in September 1967 experienced a significant rise above the 6.1% annualized trendline during the late 1990s, commonly referred to as the internet bubble era. Interestingly, a similar surge occurred briefly in 2022 before the onset of a bear market in January 2023. This observation highlights the overvaluation of equities in 1967, as it took bubble-like conditions for the post-1967 performance to align with the long-term trendline. However, it is crucial to note that this alignment is only sustainable as long as the bubble remains intact.

The Relevance to Today’s Market

Some may argue that the aforementioned illustration holds little significance for today’s stock market, given that the real total return of the S&P 500 index is currently 18% lower than its peak during the previous bull market in January 2022. Although it may appear that much of the excess has dissipated from the bubble, this argument may not be entirely persuasive.

A comparison between the S&P 500’s valuation in September 1967 and its present state reveals interesting insights. Even when considering the 18% decline in today’s market compared to almost two years ago, the S&P 500’s price/earnings ratio stands at 18.9 today, slightly higher than the ratio of 18.1 observed in September 1967. Similarly, the cyclically-adjusted price/earnings ratio has increased from 22.2 in September 1967 to 28.6 in the present day.

Takeaways and Investment Implications

The analysis of stock market performance underscores the fact that growth in the market is sporadic and clustered, with extended periods of surges and stagnation. Despite its overall upward bias over the span of two centuries, the market’s long-term growth rate is influenced by only a few exceptional years.

Therefore, it is imperative to recognize that if your investment horizon does not align with these exceptional years, you may fall short of the long-term average returns. As an investor, it is crucial to take into account the historical patterns and consider the potential impact on your investment strategies.

Conclusion

As we navigate the complexities of the stock market, it is essential to understand its historical performance and draw insights from previous cycles. The analysis of stock market trends since September 1967 reveals important nuances that can inform our understanding of the present-day market. By considering these insights and aligning our investment strategies with historical patterns, we can better position ourselves for long-term success in a dynamic market environment.

More: Don’t overlook the resilience of a well-diversified 60/40 portfolio — an insurance policy in an unpredictable stock market.

Plus: Safeguard your retirement savings against unscrupulous financial advisors – here’s how.

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