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.