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Growing profits, shrinking prices
Profit growth not a guarantee of big price rise

If I had a penny for each time I've heard the phrase "stock prices always follow profits", I'd be a rich man. That sentence is true to a point, but 2002 was one of the exceptions. Reported profits were actually up, so why did stock prices go down, down, down?

2002 earnings

According to Standard and Poors, the firm that created the S&P 500 U.S. stock index; after watching reported profits tumble more than 30 per cent in 2001, last year's reported profit for the index's 500 constituents is expected to show year-over-year growth of more than 20 per cent.

Well, we know what did happen to stock prices - they went down more than 20 per cent during 2002. However, shouldn't we have expected stocks prices to at least rise a little bit, if not by roughly the same amount of profit growth? Actually, no.

The reason has to do with a few things, not the least of which was the excessive optimism shot into the stock market's proverbial arm in 1999/2000. But it was also the fall from grace of once mighty corporations such as WorldCom and Enron - and the ensuing lack of investor confidence.

While S&P is expecting reported profit growth to be in the high teens for 2003, there's reason to believe that it won't automatically translate into a big rise in stock prices.

Historical perspective

Peter Bernstein, a respected New York-based investment researcher pointed out a startling fact in some of his recent work. He studied U.S. stock returns from the beginning of 1802 through the end of 2001 and concluded that rising prices have had little historical contribution to the stock market's total return during that time.

Instead he cites inflation and, most importantly, dividends as the primary contributors to total stock market return. (Data in Canada since 1956 shows a similar conclusion.) Over the past two hundred years, Bernstein estimates that pure price increases have accounted for no more than 1/5th of U.S. stocks' total return, while dividends have accounted for over half.

He highlights the period of 1989 through 2001 as a historical anomaly - a period during which 60 per cent of total stock returns were attributed to pure price changes. Bernstein estimates that the future will be something of a return to historical norms.

(Source of the figures: "Determining the Equity Risk Premium", Peter L. Bernstein, Equity Research and Valuation Techniques - AIMR 2002)

A look ahead

Recall that current stock prices (and the market's price to earnings - or P/E - ratio) represent the market's aggregate expectations for the future. But history has proven that "the market" is often wrong in its expectations. From the same reference noted above, Bernstein writes:

"If the run-up in the market that happened during the 1990s had been in investors' expectations at the beginning or the end of the 1980s, the Dow Jones Industrial Average would have been as high at the end of 1989 as it was at the end of 1999. In the end, capital gains are only a small part of the long-run process."

Extending Bernstein's logic to take a stab at what U.S. stocks (as a group) might generate over the next several years might go something like this:

  • the current dividend yield: just over 2% both here and in the U.S.;
  • the expected growth rate in dividends: which has historically been about 4.5 per cent annually; and
  • the change in future expectations (i.e. rise or fall of P/E ratio).

    Given those figures, we'd be looking at U.S. stock returns of no more than about 7 per cent per year. Changes in price will affect that one way or another, but that's likely to be the largest part of future returns, if Mr. Bernstein is correct.

    Keeping an eye on fees and building in proper diversification will give you a good chance of maximizing your portfolio's return potential.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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