There are only two reasons why an economy grows and only two reasons why stocks go up in price. I know this is overly simplistic, but not by much. An economy will grow if the workforce grows and if each worker produces more widgets per hour (productivity). Historically the US economy has seen work force growth of 1% and productivity growth of 2%. Voila, a sustainable real growth rate of 3%. (Note: many pundits expect these two metrics to slow in the future and the expected long term growth rate to be more like 2%).
As for the stock market, the two long term determinants are the growth in corporate profits and what investors are willing to pay for these profits (the price-to-earnings ratio). If companies earn more over the long term (see chart below) and investors are willing to pay more (or at least not pay a lot less) then stocks will rise. And this is what has happened over the past 10 decades.
The problem is that the companies that produce the long term profits can change over time. The Financial Times recently did a three part series (December 29, 30 and 31 2014) on companies that are disrupting the economy today, destroying profits of older companies and creating opportunities for newer ones. This makes it difficult to identify the right stocks to invest in. Clayton Christensen of the Harvard Business School, in his book, The Innovator’s Dilemma (1997), argues that economic disruption happens from the bottom up. For instance, Toyota established a beachhead in America in the 1950s with its low cost Corona and then moved up the price curve with more expensive models.
Today as the The Financial Times points out, it is companies like Netflix in video renting and video streaming, Uber in taxi services and Airbnb in renting rooms which are causing tectonic shifts in the marketplace. So an important question to ask is, are the companies we are investing in, the competitors of tomorrow or simply the dinosaurs who will be brought to their knees by disruption? This is the debate going on now with Staples in office supplies, and Barnes & Noble in books. Survive or fail? (ed. opinion: the jury is still out but our take is, as the last Big Boxes standing here, they will survive).
One final note from Clayton Christenson. What is his opinion of the most valuable stock (Apple) in the most valuable market (the U.S.) in the world? He thinks longer term Apple is toast. Why? Apple has been running at the highest end of the smartphone market. The iPhone rules today. But disruption and volume sales are happening at the low end and the competition is getting better. First it was Samsung and now the Chinese, led by Xiaomi (pronounced Shao – me), Lenovo and others which have their noses under the tent flap. Christenson’s argument is that the competition today has staying power due to high volume, lower end sales. They are all on a “modular” platform (Google’s Android system) not locked into a proprietary system like Apple. And we all know what happened to the last leader’s proprietary system (Blackberry).
The future is very uncertain but we are betting that growth in U.S. corporate profits and in the U.S. stock market will continue. The difficult thing is to figure out how ‘disruption’ will affect the stocks we own.
