By: Dividend Sensei
By Ben Carlson
If investing was a cocktail, it would essentially boil down to one part fundamentals and one part emotions. Fundamentals are easier than ever to capture because we now have access to more data in a single day than our ancestors would see in a lifetime.
The emotional component of investing will never be quantifiable because it’s impossible to predict how people will feel in the future.
The late Jack Bogle introduced this concept in his book Don’t Count On It by breaking down expected annual returns of the U.S. stock market into the following components:
Market Returns = Dividend Yield + Earnings Growth +/- Changes in the P/E Ratio
Dividends and earnings are the fundamental portions of stock market returns while the change in the price-to-earnings (P/E) ratio is the speculative portion of returns. The change in P/E represents how much people are willing to pay for corporate fundamentals and the reason it’s considered speculative is that it can vary widely over time.
Here’s a look at how Bogle’s data looks historically with some updated numbers through the end of the last decade:
Dividends are fairly stable over time while earnings growth has had its share of ups and downs. And depending on the decade, investors have been more or less willing to pay for that earnings growth depending on how they feel about the current environment.1
Fundamentals certainly matter over the long-term but how investors feel about the present or future can have a huge impact on stock market returns over even decade-long periods.
I could give you the earnings growth for the next decade and you still might not be able to predict how well stocks will do in the 2020s because no one has a clue how people will feel about stocks over the next 10 years.
This same idea is even more pronounced with individual companies.
Apple is up more than 400% over the past 5 years.
The company must have seen a surge in fundamentals as well, right? Revenue and earnings are up but certainly not in the 400% territory:
The dividend yield has also failed to keep up with the price spike:
So why is Apple up so much? It’s simple — the P/E ratio has gone nuts:
Apple was trading at 12x earnings as recently as January 2019. Today the company’s P/E is over 40.
Why did this happen?