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Why does it go up?
We now know what the S&P 500 performance has historically been. Then, the following questions should easily arise, why has this happened? Will it continue to go up?
The stock market indexes, and stocks as individuals, have three drivers for their value appreciation. The first one is underlying earnings growth both in the index or in a business, the latter would explain its own stock appreciation. The reasoning behind this is simple, since stocks are productive assets, as discussed in Article 1, the pricing or the intrinsic value of this respective asset should be in accordance to the cash flow it produces. Here’s an example with Apple:
EPS stands for Earnings Per Share. This would be the entirety of the earnings generated by the company divided by the amount of shares in circulation, and LTM means Last Twelve Months.
The bottom chart Is revealing what buying a share of Apple would have entitled you to earn on each respective moment. The thing is that a company is not forced to distribute every dollar earned to shareholders. Its purpose or mission is to continue growing and earning more money, that’s why a business has the right to decide whether to distribute earnings to shareholders or not. This distribution goes through dividends.
Now, lets remind again (because this is vital) that a stock is worth the present value of the future cash flows it will produce. The option to reinvest yearly earnings in the business itself allows it to generate more cash flow in the future, and that’s what creates the first and third drivers or contributors to a stock’s price. The first one, cash flow.
The second one, which will be explained in a more detailed way in the future, comes from nominal appreciation because of inflation. This stands for the long term. In the short term, there are plenty of studies showing 5-year periods where stocks actually under performed inflation.
The third one is Speculation, illustrated in the following chart:
P/E stands for Price to Earnings and NTM is Next Twelve months. This is “the multiple of forecast earnings for the next twelve months that stock investors are willing to pay for one share of the firm.” Having a P/E of 22 would imply that at today’s cost, Apple is being priced at 22 times its 12 months future earnings.
The speculative reason for a stock appreciation is visually seen in the PE chart. You can see how much does the price vary with perhaps no change in the projected future earnings. People buying the asset are simply driving up the price of something that didn’t have any fundamental change at all. This is what Philip Fisher would call “A change in the financial community appraisal of a stock.”
If it has always gone up, does it mean that it will continue to do so?
This could be answered quoting Benjamin Graham:
“Why should future returns of stocks always be the same as their past returns?”
So, short answer, no. The reason why the S&P 500 has only gone up for the past century is that the companies composing it have continuously earned more and more. The same reason goes for Apple’s continued appreciation in market value. But this is no guarantee of anything.
In investing, only the future matters. If in this future, companies composing the S&P 500 or the Nasdaq start earning less and less, the index will have no fundamental reason to go up. Of course, one would expect the index of the biggest companies in the US to earn more and more, but it’s trickier than one would think and it gets even trickier when talking about single businesses.
The reason behind it is that the S&P 500 “updates” itself to always have the biggest US companies playing for him. This could mean getting rid of Apple, for example, if it went below that threshold. So, this index is a “Get the winners here, losers get out”. A single company, on the other hand, can’t really select among different earnings, it has what it has, and that’s what will determine its stock price in the long run.