Special Edition: Can the stock market go down forever?

In this What’s Up with Stonks Special, let’s talk about whether the stock market go down forever. This piece is written in a somewhat tongue-in-cheek fashion, but with an instructive moral.

Can the stock market go down forever?

A brilliant moderator of Inderes Forum, Sijoittaja-Alokas, was messing around on the forum with an idea: what if the new normal in the next few decades is a long-term decline in the stock market? Although it was masochistic humor from a stock investor's point of view, the topic makes for an insightful discussion.

Let's get down to basics. What drives stocks in the long run? Earnings growth. This is easy to prove. The best data available is from the United States, so let's use the S&P 500 index, which we are all familiar with, as an example. Between 1960 and 2022, S&P 500 earnings per share have increased from $3.1 to $220. This means that earnings growth has been 7.1% per year.

How much the S&P 500 index has risen over the same 62-year period? 7%. This is no coincidence.

So, what drives the results? It’s economic growth because the economy is where the results are ripped from. The US economy was about $500 billion 62 years ago and about $25,000 billion last year. That’s in nominal terms. The economy has grown by around 6.4% per year.

The S&P 500's results have grown even faster than the economy. I think there are two reasons behind this. First, S&P 500 companies are international, and the global economy has grown faster than the US. Second, EPS are boosted by purchases of treasury shares. In general, earnings growth can be expected to be even slower than economic growth, as loss-making companies are listed on the stock exchange or companies carry out share issues. But in the 2000s, the collective number of shares has fallen in the US.

I always say that long interest rates reflect economic growth and inflation. Note that nominal economic growth includes inflation. Over the past 60 years, the US 10-year bond rate has averaged 5.9%, just below economic growth. This is logical. The economy can grow faster than interest rates, but not slower. Otherwise, there would not be enough money to pay the interest. This, by the way, is a good counterargument to those tinfoil wearers who think the world is drowning in interest and debt. No, it’s not.

Now that we have the facts, we can move on to consider whether the stock market can decline forever. At the same time, we can think about what the future holds for us in terms of market interest rates.

In practice, for the stock market to fall for long periods, economic growth would have to turn into economic stagnation or decades of recession. That's very unlikely. Economic growth is generated when more pairs of hands work more productively. Although the birth rate has plummeted in the West and China, the world's population continues to grow. Productivity growth has been slower in the 2000s, but productivity is still rising. There are around 8 billion people in the world and fewer of them have our high standard of living. The disparity in living standards is illustrated by the fact that an estimated 80% of the world's population has never flown in their lives. We still have a huge amount of work to do. The pursuit of material wealth will continue to grow the economy for a long time to come.

Even Finland's economy, which has a reputation for being the worst kind of flatliner, has managed to grow by a nominal 2.3% a year since 2008. Of course, taking into account the rise in prices, the real standard of living of Finns has not risen, but investors are looking at nominal developments.

Perhaps the biggest threat to almost inevitable economic growth is climate change. Estimates are imprecise, but for example Swiss Re predicts that the global economy will be 18% smaller by mid-century than it would be without climate change. Although developments in that direction look worrying, climate change will not stop economic growth. I won't comment on more existential threats to humanity, such as a meteor strike or nuclear war, in this post. Politics matters too. The hot growth market of Tsarist Russia was instantly reduced to zero when the Bolsheviks took power. The same thing happened later in China in the 1940s. Yet I would argue that in the West, the market-driven mixed economy system is on a firm footing and the stock markets are not threatened by nationalization.

In the long run, a chronic fall in the stock market is therefore unlikely for the time being. In the short term, the stock market can go to all kinds of places. - A severe recession, collapse in liquidity, rise in interest rates or decline in the profitability of listed companies can push shares lower. If the stock market goes through a proper bubble, as it did in Japan in the late 1980s and in Finland in the tech bubble of the late 2000s, it can take decades for stocks to recover. But these are extreme cases. Japan is also so far an extreme example of an economy that hasn't grown for 30 years. For the others, I think it will take a few more decades for Japanization.



As I said, in the long run, continued economic growth will also boost results.

What kind of future does the market foresee? Starting with the example of the United States so that the logic becomes clear. As we have just seen, bond rates reflect nominal economic growth and inflation. The interest rate on the US 10-year bond is now around 4.5%. The interest rate on the inflation-linked bond is about 2.2%, so the market expects the US economy to grow in real terms (adjusted for inflation), by about 2.2% per year for the next ten years.

Fair enough. Thus, we can expect the S&P500 results to increase by at least 4.5% on average. Given that companies are buying their own shares and making profits at a nominal rate of around 6% in a growing global economy, I would roughly estimate that at least 5% earnings growth is a perfectly realistic expectation. Add to this a dividend yield of 1.5%, and the expected return on the US market would be 6.5% in nominal terms. That's a bit low because, as mentioned, the return without dividends alone has been around 7% and with dividends as high as 10% per annum for the last 60 years. Looking back on history, the S&P 500 index looks expensive. That or results would have to grow faster than expected.

Let's make the same calculations for Nasdaq Helsinki. Since the Finnish bond market is not liquid, we have to pull a few tricks from our sleeve. The Bank of Finland forecasts that Finland's economy will grow by 1.2% a year in the coming decades. As I mentioned in my latest post, the market expects German inflation to average 2.4% over the next 10 years. Let's use that assumption also for Finland. Thus, Finland's GDP would grow by 3.6% per year in nominal terms. Since Finnish companies are making more profit globally, that growth is rounded up generously to 4%. Coincidentally, the performance of the Nasdaq Helsinki Balanced Index has increased by a good 4% in recent years, according to Bloomberg.

On top of the earnings growth, the investor receives a dividend yield of 4.5%. Together, that would be 8.5%. The real return (the one adjusted for inflation), would be 6.1%. That's more than the real return of around 5.5% on the Helsinki Stock Exchange over the last 100 years. Thus, Nasdaq Helsinki looks very interesting. Unfortunately, the Finnish stock market is quite concentrated, so even a single stumble by Nokia or a slip by Nordea or a mega-success of a large company can swing these figures. So, please take these as rough assumptions.

By the way, it's strange when economists, analysts and investors are always complaining about how the future is so uncertain. In the short term, the economy and stocks can go wherever they want, but every day the market offers the best possible guess for long-term economic growth and inflation. There’s no mystery in it. If you invest in stocks over a 5-year horizon, you can pretty safely look at these long-term market assumptions. These too are just super-educated guesses, and anything can happen, but they work great for everyday investing.

Stressing about short-term cycles is pointless – it’s better to think about long-term trends. You can mirror these forecasts to the companies in your own portfolio and see whether they can grow faster or slower than the general economy for a while. If such a forecast cannot be made in a company with a sufficient level of confidence, that stock can always be left for others to worry about.

To sum it up, the answer to the question is that the stock market is unlikely to go down for decades. And the more it goes down in this bear market, the better the expected return in the future.

Thanks for reading the post! Look at the long-term trends and make good stock picks!