Sometimes when I come across an interesting investment illustration, I will take a picture of it on my phone to revisit it later. You might do the same with quotes or pieces of an article you read. I think of it like a “digital dog-ear” of sorts. I have probably saved the illustration you see below three or four times, so it’s about time I finally make use of it!
Stockholder vs Corporate Earnings
The chart(1) to the right compares the S&P 500 Price Index (excluding dividends) in green with the trend of S&P 500 Operating Earnings* in blue.
I like this chart for several reasons. First, it shows that over the long run, the return we earn as stockholders tracks closely with the earnings or profits the businesses generate. This fact takes some of the mystery out of stock investing. You can get caught up in current headlines, forecasts, and all sorts of financial market data. In the long run, however, business owners receive returns on their money from the profits of the underlying businesses. Pretty simple.
Investor Sentiment and the Market
Second, the lines occasionally diverge when investors become, for whatever reason, either a bit too optimistic or pessimistic. For instance, market prices in the late 1970s and early 1980s, in hindsight, were too low in relation to the earnings of the companies. Conversely, investors became too optimistic in the late 1990s, and market prices got away from underlying profits. These periods ultimately corrected, with market prices generally coming back in line with earnings.
The Impact of Global Factors
Third, the relatively steady march higher in corporate earnings happened throughout all sorts of tumultuous environments and periods of uncertainty. Wars, stretches of high inflation, banking crises, real estate busts, political turmoil, and pandemics were not enough to stop the trend of gradually increasing earnings. Sure, we can spot temporary profit declines, some of which were severe. For instance, the financial crisis of 2008–2009 stands out. Eventually, however, business got back on track almost as though these setbacks never happened.
So, when we encounter periods of significant change or uncertainty, it may be helpful to remember we’ve seen many such instances in the past. Yet the growth in corporate profits and the relationship with long-term stock returns carry on.
First Quarter Performance
U.S. stocks began the quarter with positive returns before turning lower in the middle of February. During a roughly one-month stretch in February and March, U.S. stocks declined approximately 10%. Domestic tech giants like Apple, Amazon, Meta, and Nvidia suffered worse declines than the broad market.
Broadly diversified portfolios fared much better. For the quarter, non-U.S. stocks, real estate securities, and interest-generating investments (bonds) all turned in positive returns while U.S. stocks ended the period in negative territory.
Some clients have been surprised by the resilience of their investment portfolios amidst the recent weakness in U.S. stocks. One client remarked: “This is why we diversify!” Yes, diversification helps to smooth out returns and reduce reliance on any one asset class. Diversification is not perfect and does not offer blanket protection against investment losses. But it remains a tried-and-true approach for dealing with a world of investment volatility in which no one has a crystal ball.
As always, we look forward to our next conversation.
