The Grand old Duke of York he had ten thousand men…
He marched them up to the top of the hill…
And he marched them down again.
When they were up, they were up…
And when they were down, they were down…And when they were only halfway up…
They were neither up nor down.
Indeed, the U.S. stock market has been both up and down without making much progress in 2015.
Looking back, the market started the year off strong which was followed by a February swoon. Stocks reversed course and headed higher during the spring and early summer with the indexes seemingly hitting record highs every day.
In late July, the market’s winning streak came to an end and it headed back down again. In fact over the past week or so, the Dow posted its longest consecutive-day losing streak in the past four years.
Yet, after all this movement, just as with the Duke of York, the US stock market is essentially flat for the year — up just a bit over 1 percent for 2015 as measured by the S&P 500 – despite all the ups and downs.
What’s Going On?
There’s one primary reason that stocks are struggling to advance this year. It’s because we are in a slow-to-no-growth world. You can disregard anything else the mainstream media is saying.
That’s because without growth, stocks can’t make meaningful progress from their current levels.
Let’s dig deeper and I’ll explain why and, more importantly, the actions you should be taking in your portfolio.
3 Factors Determine Stock Market Returns
Did you know that there are three and only three factors that determine stock returns?
That’s right there are just three factors that determine the returns for individual stocks and the overall stock market.
These three factors are:
(1) Dividend yield
(2) Earnings growth rate
(3) Revaluation or change in P/E multiple
All three factors are expressed as a percentage. And all you have to do is add them together to get your expected total return number. And better yet, you’ll know one of the factors — current yield — at the time you buy the stock.
Stock Market Returns in 2013 and 2014
Let’s use our model to look at the total return earned from the US stock market for 2013 and 2014.
Looking at these charts, it’s obvious that most of the stock market gains for 2013 and 2014 came from revaluation. That means the reason that stocks went higher in 2013 and 2014 was simply because investors were willing to pay more for a dollar of earnings at the end of each year than they were at the beginning of the year.
As a professional investor, that’s scary. Why do I say it’s scary?
That’s because investor’s moods can swing dramatically and when their sentiments do change from optimism to fear, then the revaluation component for stocks will flip-flop causing this element of stock market returns to turn negative.
Stock Market Returns in 2015
Now, let’s use the same model to analyze the return on US stocks so for this year.
From this chart, it’s obvious that the market is essentially flat for the year. But despite the lack of any meaningful stock market advance, there is a speck of good news in 2015’s numbers.
And this small bit of good news is that investors have, at least for now, stopped bidding up the price they are willing to pay for a dollar of corporate earnings. We know this because there has been no change in the revaluation component of our model.
The bad news is that, in aggregate, there’s also been no growth in corporate earnings to push the market higher.
In this environment, what should an investor do?
Growth and Dividends are Key
To earn enduring profits in a slow-growth world and to hedge yourself from investor mood swings, you should focus on the two sustainable components of stock returns: dividends and growth. These are the essential elements that will propel your portfolio higher over time and provide the ultimate hedge to protect your nest egg in times of fear.
That’s why a carefully selected group of growth stocks should form the core of your portfolio. Companies with high earnings growth rates, such as Apple, Amazon, Facebook and Google, when purchased at the right price can provide a real boost to your portfolio. Investors that prefer exchange traded funds should consider the iShares Morningstar Large-Cap Growth ETF (JKE).
You’ll need to do your homework, be selective and buy at the right price so you feel comfortable holding your positions, and perhaps adding to them, when the market dips or even falls substantially.
By investing in high-quality growth stocks in which you have conviction, you can sleep well at night knowing that the high-quality companies in your portfolio are grinding away, growing their earnings day-after-day, month-after-month and year-after-year, even while you are resting. The compounding effect of this earnings growth is truly amazing.
Legend has it that Albert Einstein once said compounded savings was the greatest invention in human history. Regardless of whether Einstein actually made the observation, investment compounding has made investment icon Warren Buffett one of the wealthiest people in the world.
In fact, Charlie Munger, Warren Buffett’s longtime investment partner, has repeatedly said: “Understanding the power of compounding and the difficulty in achieving it is the heart and soul of understanding a lot of things.”
By investing in growth stocks, you’ll put the power of compounding on your side and avoid the temptation to act like the Duke of York — marching your portfolio up and down the hill while going nowhere.
Instead, you’ll have the confidence to let the earnings compound knowing that it’s earnings growth that will cause your portfolio to soar!
Bill Hall is President, managing director, and senior investment counselor at Plimsoll Mark Capital, a Maine-based firm that provides financial, tax, and investment advice to wealthy families. In 2012 he published his first book “Changing the Game: How to Profit From Your Passion for Sports“.