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The Three Components of Stock Market Return

April 25, 2022 by Lazy Man Leave a Comment

I was reading an article in Kiplinger’s Magazine something unusual caught my attention. I haven’t seen it talked about very much (if ever) in personal finance circles.

Did you know there are three components of stock market return? If you invested $100 in a stock index and it is up to $120, it’s always because of one or more of these three things. This can be very helpful in looking at how the stock market has performed in the past and might perform in the future.

The Three Components of Stock Market Return

1. Dividends

The easiest component to explain is dividends. Many companies pay out dividends as a way to share profits with investors. Some investments like Real Estates Investment Trusts (REITs) pay investors almost all their profits in dividends. It’s not unusual to get checks each year that add up to 8-10% of what you invested. In these cases, the other two components that I’m going to cover typically don’t contribute much.

There are also companies, often tech companies, that pay no dividends at all. With these companies, you are hoping that the other two components work to make your investment grow in value.

Finally, there are companies in the middle. They pay out a little dividend, but they also benefit from the other two components. Most companies fit in this range.

Dividends are usually the smallest component of the three. Overall, they don’t change that much.

2. Price-Earnings Expansion

Seasoned investors recognized that heading and know it’s about Price/Earnings Ratio (or P/E). For those who are newer at investing, this is the stock price divided by the company’s earnings. Generally, you want to pay as little money (low stock price) for the most amount of earnings. That way the company can pay out bigger dividends or use those big earnings to invest in new businesses that grow.

Back when I started investing in the mid-1990s, the average P/E ratio was between 15-20. During the internet investing craze around 2000, it jumped to 43, before the stock market crashed – and it went back to about 15. In late 2020 it was between 35 and 40. Recently, it’s come back down to around 25 as companies are making more profits and the stock market has gone down a bit since the start of the year.

When the stock market in the internet craze went up a lot, people made a lot of money on price-earnings expansion. Those were craze days when Amazon was losing money and people were investing in Pets.com because they had a cool sock puppet. Remember when Webvan blew billions of dollars trying to set up a grocery delivery service – clearly that was an idea that would never catch on, right? My roommate would joke that it should be called Amazon.org. I could give examples all day.

Back then many of those tech companies didn’t make real earnings. Investors lost patience and the big gains in the stock market disappeared in the crash. The P/E expansion from 15 to 43 when back down to 15. If you happened to sell at the height of that expansion, you would have made a great profit on your investment. In a related thought, I want to borrow your crystal ball.

Recently, the P/E got to 40 again, but the market hasn’t crashed. It went down about 10%, earnings went up, and the P/E is still a little high at 25. One of the reasons why the stock market is up is simply because people are willing to pay a higher price (25 P/E) than typical (15 P/E). Instead of the bubble bursting like in 2000, it feels like the air is getting let out a little slowly.

3. Earnings per Share Growth

Remember that Amazon.org story for the last section? It seems like Amazon decided that it would rather make money. They’ve done a tremendous job of it over the last 20 years. If you were an investor you didn’t see the P/E expansion. In fact, the P/Es were very high when it was just barely turning a profit. Instead, the explosion in earnings has meant that the P/E has gone down. People are willing to pay a much higher price because they are getting great earnings.

Amazon is also an example of a company that doesn’t pay dividends. If you have been a long-term investor in Amazon you’ve made a lot of money and probably aren’t that worried about not getting dividends.

Putting the Three Components Together

What happens when we take all the components and combine them? Dividends are important over the long run, but they don’t significantly move the market.

The other two things, P/E expansion, and earnings growth move the market. When the P/E is above 40, it’s a long shot to expect further P/E expansion. It seems more like to expect the P/E to go down towards its norm between 15 and 20. That would cause the market to go down and you to lose money in your investment. At a P/E of 25, the stock market isn’t too high right now. I could see some P/E expansion or some P/E contraction. The P/E may also not move at all. My best guess is that the market isn’t going to skyrocket from P/E expansion where it is now.

On the other hand, companies are doing well with earnings. I don’t have a good handle on whether they can continue to do better. The United States Gross Domestic Product is very good, so maybe corporate earnings will continue to go up.

As I saw the P/E of the general market get high, I decided to be more defensive. I bought iShare’s HDV, which is a high-dividend ETF. It has a lot of household names that make money because people need to buy their products and services. It also has a P/E of around 18 – historically it is very average and more likely to expand than contract in my opinion. Over the last 6 months, the Vanguard’s Total Market ETF (VTI) has lost about 7%. Over the same time, HDV is up 7%. Getting defensive has turned out to be a great move lately.

Once I started to break down investing into these components it got a little easier for me where things might be headed as far as the return on investment goes, and adjust my decisions accordingly. I think it’s important to note that I didn’t sell and exit the market. I simply moved some of my money to a place that I felt would work out better given the valuations and trends.

Filed Under: Uncategorized Tagged With: dividends, earnings, P/E

Alternative Income Streams – January 2009

January 7, 2009 by Lazy Man 3 Comments

If you are a regular reader, you are probably aware that each month, I post my alternative income earnings. These are earnings that I make not by directly working for a a set salary or hourly wage. For instance, dividends or investment gains fit the bill of alternative income. Earnings from this website counts too… I never know exactly how much I make, but I know that I’ll make something even if I disappear to Australia and Thailand for a month (as I did last year). I’m a huge fan of alternative income. When paired with frugality, it allows me to live a relatively Lazy existence. The dollar numbers aren’t putting me on easy street yet, but I see a lot of growth ahead.

Let’s get down to the nitty-gritty, shall we? Last month, I made $1971 after taxes on my websites. December is always an odd month for Lazy Man and Money. Traffic is down because people are out shopping, attending holiday parties, or simply doing stuff that’s probably just a touch more fun than reading about personal finance. On the positive side, if I make good gift recommendations on my websites, I can earn a small percentage of the sale from the merchant as a commission.

For those keeping track at home (and I doubt you are), I made $9 more in alternative income in December 2008 as I did in January 2008. Maybe I should take back the previous comment of seeing growth ahead. It was a topsy-turvy year where most of ad sales started as direct sales, but ended as mostly AdSense or affiliate sales. Bloggers that are more popular than I say that’s healthier mix for long-term growth.

While on the topic of alternative income, I should mention that in the next few days/weeks, I’ll be profiling someone who is making more than 5 times as much as am I a month – chances are you never heard of him.

Filed Under: Alternative Income Tagged With: affiliate sales, dividends, earnings, gift recommendations, investment gains

Getting Ready to Buy Some Stock

August 1, 2011 by Lazy Man 24 Comments

Wednesday my wife said, “You know we have a lot of cash sitting around, we should start to invest it while everything is cheap.” It’s amazing how I can write about this stuff everyday, while she spends about 4 minutes a year on it, and we both come to the same conclusion. Then Thursday happens and the stock market store just slashed prices another 7%. Friday morning, I hope to open up a Zecco account (why do people pay commissions?) and see how quickly we can get some money in the market. I say “hope”, because I expect them to give me lots of paperwork and/or ask for me to fax something. Faxes don’t work well with my Vonage phone lines.

I make it sound like an easy decision to invest. We have a long-term view and could wait out quite a bit of a downfall. I realize that earnings and cash-flow are likely to drop making stocks, even at this price, fairly valued. Still, I have to agree with Chad at Sentient Money when he says, “This market might be the best buying opportunity in the next 10 years.”.

So what would I buy? I think, I’ll stop by Vanguard and look for some cheap broad-based ETFs. My first target will be to load up on Total Stock Market ETF (symbol: VTI). I’ll add some Small-Cap ETF (symbol: VB), just to overweight ourselves in that area a little bit. I would also look to their REIT ETF (symbol: VNQ) to diversify quite a bit. I may then look to diversify more by looking at PowerShares DB Oil Fund (symbol: DBO) and PowerShares DB Agriculture Fund (DBA). These last two typically go up as oil and food prices go up. This is a great hedge and if oil goes back up to $140 a barrel, we’ll have solid stock gains to offset the pain at the pump.

Would you buy tomorrow? If yes, how would you reduce risk, but still try to capitalize on these relatively cheap prices.

Update: Looks like it might take a few days to get the Zecco account set-up. I did everything to set up an active account yet it doesn’t look like I have an account set up to fund. Once I do have an account set up, I will need to decide how to fund it. If I go with the free ACH method it’s going to take 5 days. If I going with the wire transfer it will cost $20, but be quick. I’m leaning towards the wire transfer at this point.

Filed Under: Investing Tagged With: earnings, Money, stock market, Stocks

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