This is a guest post by Rob Bennett, the author of Passion Saving; The Path the Plentiful Free Time and Soul-Satisfying Work. You can read more at the Passion Saving website.
I’ve spoken to a good number of investors in their 20s and 30s who are concerned about the poor performance of U.S. stocks in recent years. How are they going to accumulate the assets needed to finance a retirement when stock prices are no longer moving upward?
The problem is to a large extent an illusion. If you were planning to buy a new car soon and you were reading in the papers that car prices were headed downward, would you see that as a good thing or a bad thing? Well, it works the same way with stocks. Investors in their 20s and 30s will be putting a lot of money into stocks in coming years. They will end up better off if prices come down than they will if prices go up.
In fact, prices must come down if we ever again are to see the sorts of returns from stocks that allowed earlier generations to use stock investing as their path to secure retirements. Stocks have never provided strong long-term returns going forward from the sorts of prices that apply today. What has always happened in the past is that stock prices have come down hard from these price levels. After the big price drops, stocks were again positioned to provide an outstanding long-term value proposition.
Stock Return Calculator
I am the co-developer (with John Walter Russell) of a calculator that tells you what you need to know to tell if stocks are priced well or not. It’s called “The Stock-Return Predictor” and it employs a regression analysis of the historical stock-return data to let you know the likely annualized real return of stocks starting from all possible valuation levels. You’ll see from spending a little time with the calculator that stocks are an entirely different asset class when they are priced as they are today compared to when more reasonable price levels apply.
Today’s P/E10 (that’s the price of the S&P 500 index over the average of the past 10 years of earnings) is 25. The most likely 10-year return is only 1.55 percent. You can probably do as well or perhaps even a bit better in far safer asset classes.
But look at what happens when the P/E10 level drops to 14, the fair- value price. The most likely 10-year return jumps to 6.34 percent. If the P/E10 level drops to 8, which is what normally happens in the wake of a huge bull market, the most likely 10-year return jumps to 14.51. All of your concerns about financing a retirement disappear after a hard price drop!
We need a big price drop. We need one badly.
The reason why price drops make many of today’s investors anxious is that we were told so often during the huge bull that stocks are always the best investment for the long run and most of us are wildly overinvested in stocks today as a result. The answer is to learn how valuations affect long-term stock returns, to lower our stock allocations to more reasonable levels, and to come to appreciate the long-term benefits that come from big price drops starting from the sorts of price levels that apply today.
You’ll view big price drops very differently when your stock allocation is lower. Those with reasonable stock allocations are able to see that low stock prices are the key to long-term wealth accumulation.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.