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Caution to Stock Investors: Recent Growth in Stock Prices Is Unsustainable

June 20, 2017

Summary: The stock market has grown significantly more expensive over the past several years. Now is the time for stock investors to exercise utmost caution and avoid speculation.

  

Over the past five calendar years, the 500 largest American businesses have increased their sales by only 10% or so, while stock prices have soared by 78%. And so far this year, the market has shown no signs of stopping – growing an additional 9% in less than six months!

  

It is possible, and indeed highly likely, that American businesses will continue to grow modestly in terms of sales, earnings, assets, etc. decade upon decade into the future. Based on historical rates of return on equity capital, as well as the percentage of earnings that are retained and reinvested for growth, an annual growth rate of 4-6% through the business cycle for large American businesses is probably a fair assumption.

  

What is categorically not possible is that stock prices will forever grow at a faster pace than underlying businesses. 10-20% growth is not sustainable. Eventually, the rate of increase for stock prices must be justified by similar growth in sales, assets, profits, etc.

  

Here’s my brief perspective on today’s stock market conditions. Stocks will almost certainly beat U.S. government bonds over a twenty-year period, but their superiority is questionable over much shorter periods. Even over a rather long span of ten years, I would hesitate to put too much confidence in the stock market outperforming 10-year treasuries, which today are only yielding a little more than 2% per annum. 2% is anything but a high hurdle, and I guess the market will probably beat it, but such an outcome is certainly no gimme. The higher stock prices go, the lower their future returns. It is as simple as that.

  

Today’s market conditions make caution absolutely imperative. In my own portfolio, I find that I am concentrating more of the portfolio in safer, less exciting issues. Such activity is a result of fewer bargains. Admittedly, returns are unlikely to be lucrative over the next several years, but it is futile to fight against gravity. One has to do the best with what one is given. No, today’s market is not ideal for “home run” swings. Lower expectations are appropriate, and prudent.

  

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