Millionaire Teacher (10 page)

Business earnings and stock price growth are two separate things, but long term, they tend to reflect the same result. For example, if a business grew its profits by 1,000 percent over a 30-year period, we could expect the stock price of that business to appreciate similarly over the same period.

It's the same for a stock market index. If the average company within an index grew by 1,000 percent over 30 years (that's 8.32 percent annually) we could expect the stock market index to perform similarly. Long term, stock markets predictably reflect the fortunes of the businesses within them. But over shorter periods, the stock market can be as irrational as a crazy dog on a leash. And it's the crazy dog's movements that can—if we let them—lure us closer to poverty than to wealth.

True stock market experts understand dogs on leashes

I used to have a dog named Sue who behaved like we were feeding her rocket fuel instead of dog food. If you turned your back on her in the backyard, she'd enact a scene from the U.S. television show
Prison Break
, bounding over the five-foot-high fence in our yard and straining diplomatic relations between our family and those whose gardens she would destroy.

When I took her for extended runs on wide, open fields, she was able to burn off some octane. I would run in a single direction while she darted upward, backward, right, then left. But collared by a very long rope, she couldn't escape.

If I ran from the lake to the barn with Sue on a leash, and if it took me 10 minutes to get there, then any observer would realize it would take the dog 10 minutes to get there as well. True, the dog could bolt ahead or lag behind while sticking its nose in a gift left behind by another canine. But ultimately, it can't cover the distance much slower or much faster than I do—because of the leash.

Now imagine a bunch of emotional gamblers who watch and bet money on leashed dogs. When a dog bursts ahead of its owner, the gamblers put money on the sprinting dog, betting that it will sprint far off into the distance. But the dog's on a leash, so it can't get too far ahead of its owner. When the leashed dog gets ahead, it's destined to either slow down or stop—so that the owner can catch up.

But the gamblers don't think about that. If they see the dog bounding along without noticing the leash, they place presumptuous bets that the dog will maintain its frenetic pace. Their greed wraps itself around their brains and squeezes. Without that cranial compression, they would see that the leashed dog couldn't outpace its owner.

It sounds so obvious, doesn't it? Now get this: the stock market is exactly like a dog on a leash. If the stock market races at twice the pace of business earnings for a few years, then it has to either wait for business earnings to catch up, or it will get choke-chained back in a hurry. But a rapidly rising stock market can cause people to forget that reality. I'll use an individual stock to prove the point.

Coca-Cola Bounds from Its Owner

From 1988 to 1998, the Coca-Cola Company
www.coca-cola.com
increased its profits as a business by 294 percent. During this short period (and yes, 10 years is a stock market blip) Coca-Cola's stock price increased by 966 percent. Because it was rising rapidly, investors (including mutual fund managers) fell over themselves to buy Coca-Cola shares, pushing the share price even higher. Greed might be the greatest hallucinogenic known to man.

The dog (Coca-Cola's stock price) was racing ahead of its master (Coca-Cola's business earnings). A rational share price increase must fall in line with profits, correct? If Coca-Cola's business earnings increased by 294 percent from 1988 to 1998, we would assume that its stock price would grow by a percentage that was at least somewhat similar, maybe a little higher and maybe a little lower. But Coca-Cola's stock price growth of 966 percent was irrational, compared with its business earnings increase of 294 percent.
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Can you see what happened to the blazing Coca-Cola share price in
Figure 4.1
when it got far ahead of Coca-Cola's business profits?

Figure 4.1
Coca-Cola's Stock Price vs. Coca-Cola's Earnings

Source:
Value Line Investment Survey

The dog eventually dropped back to meet its owner. After blazing ahead at 29 percent a year for a decade (from 1988 to 1998) Coca-Cola's stock price eventually “heeled.” It had to. You can see by the chart that the stock price was lower in 2011 than it was in 1998.

Coca-Cola's earnings growth and stock price were realigned, much like a leashed dog with its owner.

You can look at the earnings growth of any stock you choose. Over a long period, the stock's price might jump around, but it will never disconnect itself from the business earnings. To see a few examples for yourself, you can log on to
The Value Line Investment Survey
<
http://www3.valueline.com/dow30/index.aspx?page=home
>. The U.S. research company offers free, online historical data of the 30 Dow Jones Industrial stocks.

The Madness of People

Coca-Cola wasn't the only business with a share price that was out of step with its business earnings. Stock market investors worldwide euphorically flocked to stocks in the late 1990s, as they were motivated by . . . rising prices. The stock buying grew more frenzied during the latter part of the decade as stock prices reached lofty new heights. The U.S. (for example) went through a period of strong economic growth during the 1990s, but the prices of stocks were rising twice as fast as the level of business earnings. It couldn't last forever, however. The decade that followed saw the racing, leashed dogs eventually fall back in line with their owners who were moving at a much slower rate.

Global stock markets also took a breather between the year 2000 and 2010, rising just 21 percent for the decade, after climbing 250 percent between 1989 and 1999, as measured by the MSCI index of developed country stock markets.
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Stocks Go Crazy Every Generation

Long term, whether we're talking about Coca-Cola or a stock market index, there's one reality: the growth of stock market prices will correlate themselves directly with the growth of the businesses they represent. It's supply and demand that pushes stock prices over the short term. If there are more buyers than sellers, the stock price (or the stock market index in general) will rise. If there are more sellers than buyers, stocks will drop. And when prices rise, people feel more confident about that investment. They buy more, pushing the price even higher. People become drunk on their own greed, not recognizing that bubbles form when price levels dramatically exceed business profit growth.

“History Doesn't Repeat Itself, But It Does
Rhyme”—Mark Twain
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As far back as we have records, at least once every generation, the stock market goes bonkers.
Table 4.3
shows three periods from the past 90 years showing the U.S. market as represented by the Dow Jones Industrial stocks. You can see, in each case, share price levels that grossly exceeded earnings levels, and the terrible returns that followed as the “dogs” were caught by their “owners.”

Note from 1920 to 1929, the Dow stocks' average business growth amounted to 118 percent over the 10-year period. But the prices of the Dow stocks increased by 271.2 percent over that decade, so if someone invested in all 30 Dow stocks in 1920 and held them until 1929, they would have gained more than 271 percent not including dividends, and close to 300 percent including dividends. Because stock prices can't exceed business growth for long, the decade that followed (1930–1940) saw the stock market fall by an overall total of 40.9 percent. Again, the leashed dog can't escape its owner.

Table 4.3
Prices of Stocks Can't Outpace Business Earnings for Long

Note: Figures do not include dividends

Source:
The Value Line Investment Survey
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The two other time periods during the past 90 years where investors lost sight of the connections between business earnings and stock price appreciation occurred from 1955 to 1965 and from 1990 to 2000. You can see the results in
Table 4.3
.

Anyone investing in a broad U.S. stock market index would have gained more than 300 percent (including dividends) in the 10 short years between 1990 and 2000. Did business earnings increase by 300 percent? Not even close. That's the main reason the markets stalled from 2000 to 2010.

How does this relate to you?

Every generation, it happens again. Stock prices go haywire, and when they do, many people abandon conservative investment strategies. The more rapidly the markets rise, the more reckless most investors become. They pile more and more money into stocks, ignoring their bonds. And when the markets eventually fall or stagnate, they curse their bad luck. But luck has little to do with it. The blame rests on investors' lack of discipline or their ignorance about the stock market.

Internet Madness and the Damage It Caused

The greatest Titanic period of delusion sailed during the technology stock mania of the late 1990s. The stocks that were riskiest were those companies with the greatest disconnection between their business earnings and their stock prices.

Many Internet-based businesses weren't even making profits but their stock prices were soaring, pushed upward by the media and the scintillating stories of Silicon Valley's super-rich. Most of their investors probably didn't know that there's a direct long-term connection between stock prices and business earnings. They probably didn't know that it's not realistic for businesses to grow their earnings by 150 percent a year—year after year, no matter what the business is. And if businesses can't grow earnings by 150 percent on an annual basis, then their stocks can't either.

Some of the more famous promoters at the time were such high-profile financial analysts as Morgan Stanley's Mary Meeker, Merrill Lynch's Henry Blodgett, and Solomon Smith Barney's Jack Grubman. But they might have a tough time showing their faces today. For all I know, the top Internet stock analysts of the 1990s are finding a safer, more peaceful existence in the jungles of Borneo. I can imagine a few people wanting their heads. Their media-thrown voices tossed buckets of gas on the flames of madness when technology-based companies without profits were priced in the stratosphere. Meeker, Blodgett, and Grubman were encouraging the average person to buy, buy, buy.

One difference between this period and the bubbles of previous generations was the speed that the bubble grew, thanks to the Internet as a rapid communication channel. One trans-generational similarity, however, was the investors' attitude that “this time it would be different.” In each period where stock prices disconnect from earnings levels, you find people who think that history is going to rewrite itself, that stock prices no longer need to reflect earnings, and that leashed dogs everywhere can develop mutations, grow wings, and lead flocks of Canadian geese on their way to Florida. Long term, stock prices reflect business earnings. When they don't, it spells trouble.

Even shares of the world's largest technology companies sold at nosebleed prices as they defied business profit levels. And, as shown in
Table 4.4
, when cold, hard business earnings eventually yanked the price leashes back to Earth, people who had ignored the age-old premise (that business growth and stock growth is directly proportional) eventually lost their shirts. Investing $10,000 in a few of the new millennium's most popular stocks during 2000 would have resulted in some devastating losses for investors.

Table 4.4
How Investors were Punished

Source:
Morningstar and Burton Malkiel,
A Random Walk Down Wall Street,
2003
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