You invest in stocks because you believe their value will increase over time; but have you ever wondered why they go up? If you know the answer it will change the way you invest.
The basics
The first thing to remember is a stock represents a share of ownership in a company. Though it might not feel like it, when you own stock, you are an owner of a company.
Second, you don’t have to keep your stocks forever. A secondary market, called a stock exchange, allows you to buy and sell stocks seamlessly and without delay. Because of technology, at any point during the day you can see the price of a given stock and can buy or sell that stock with the click of a button.
The voting machine versus the weighing machine
The voting machine
Say you own a share of Amazon. You look online through your broker’s website and see the price of one share of Amazon is quoted at $124.24. Who exactly determines this price? That’s the beauty of a stock exchange. This price is one that millions of investors have agreed upon. This is the amount someone is willing to pay for your share of Amazon.
So why do stocks go up? In the short-term, the price is determined by a number of factors. Sentiment, how these millions of investors collectively “feel” about Amazon, the economy, or their own financial situation can all cause the price of Amazon to swing daily. Similarly, a major news headline, a panic, or an existential shock (like a war) can cause short-term volatility in its price.
That’s why the famous investor, Benjamin Graham, described the stock market like this: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
He describes the short-term price fluctuations as ballots cast by voters. Voters are known to be fickle and swayed by emotion. Need proof? Since 1934 every midterm election but two has swung against the political party that won the White House only two years prior.
The same goes with short-term investors. The price of Amazon today will be different from the price of Amazon tomorrow. Did Amazon’s business model change in one day? Probably not. But the sentiment of investors and the interpretation of that day’s news rules the price you see.
The weighing machine
When focused on the short-term, the stock market seems like a casino. And it can be—if you are a short-term trader.
But why do stocks go up over the long-term?
Graham describes the market as a “weighing machine” in the long run.
A weighing machine is objective and known for accuracy—not easily swayed or subjective. This metaphor means that long-term market prices are driven by something that is measurable and trustworthy, namely, the financial earnings and dividends of these companies.
Earnings are what a company generates by selling its products or services. Earnings are the “bottom line”. As a collective, US companies have a history of growing their earnings. Remember how you are an owner of these companies by owning their stock? This means you have a part of their earnings.
Simply stated: over the long run, stock prices follow earnings.
This chart shows the earnings growth of the S&P 500 since 1988. Earnings for US companies have grown by 6.42% per year since then. Looking back even further confirms this trend. In 1928, the earnings per share of the S&P 500 was $1.11. Today it’s just over $200.
But earnings don’t increase every year. Those shaded gray areas are recessions. In every recession, earnings have briefly interrupted their long term trend. But as you can see, the declines have been only temporary. It doesn’t take long for US companies to continue their bottom-line growth.
Similarly, the amount of money paid out through dividends has increased over time. Dividends are one of the ways you as an owner get paid to own stocks. Not only can stock prices appreciate, but you can also receive cash payments because of good earnings.
The dividend per share of the S&P 500 was $0.63 in 1940. Today it’s $64.02. That’s a 5.78% annual growth rate. Even though they can get cut during recessions, dividends are even more stable than earnings. Several recessions saw continued dividend growth! Even though the stock prices took a hit, the dividend continued to be paid.
Companies generate earnings and dividends, and these grow over time. Earnings have grown around 6% per year, while dividends have grown at a similar rate. Wouldn’t you expect your stock prices to trend up if your cash flows are ever increasing?
You are an owner of these companies. Therefore, you participate in the growth of these companies, too.
This should change the way you invest
I made a statement that understanding why stocks go up will change the way you invest. We are so focused on the short-term: today’s price, this month’s returns, year-to-date performance, etc. In these times, the voting machine wins out. We forget about the factors that ultimately matter the most to stocks—the weighing machine of earnings and dividend growth.
As this year has shown, the prices of stocks can go deeply negative. Drops of 20% or more occur about every five or six years. When you are in the middle of one of these major drawdowns, it’s easy to think this time is different and there’s no way things can recover.
But capitalism is resilient. The trend is up and to the right, with brief periods of stress. Earnings will recover, dividends will continue to be paid, and US companies will prosper.
Investing is simple but rarely easy. Where else can you participate in the earnings and growth of great American companies? The price of admission is a periods of stress driven by fickle voters. The reward is an increasing income stream followed by higher prices.
