Is there such a thing as an "average" year?

Since we're coming up on the end of the year, we'll no doubt hear about how the next year will be an "average" year.  Very nearly every year I've followed the markets, just about every market commentator, or at least two-thirds of them, have called for a "typical" year of stock market performance.  If it was a bad year in the prior year, they'll say "Things were tough and we're still coming back so I think it will be a slow, average year of recovery."  If it was a good year, "We saw some good things last year, so we'll probably be coming off that somewhat and go back to a more typical rate of return." Even if it was an average year, they would use that as the basis for forecasting an average year.

The reason for this is all very simple, which is that people have an immutable faith in the central tendency of a long-running time series.  The problem is that stock market returns don't follow anything close to a normal distribution (CLICK ON PICTURE FOR LARGER IMAGE):

First of all, I would like to point out that there is a big difference between the compounded annual growth rate (CAGR) and the "average".  This is because averages almost completely ignore the effect of significant down years.  To explain it in a clear example, if you drop 50% in the first year and rise 50% in the next year, the two year average is 0%, but you're actually down 25%.  The CAGR captures this, but the average does not.  As such, the long term typical rate of return is about 140-150 basis points lower, depending on how you draw your time horizon.  The difference is notable, by the way.  At 7.9% per year over 40 years, $1,000 turns into $20,932.  At 6.5% per year over 40 years, it's $12,416.  In other words, please don't base any projections you are doing for your retirement on the average rate of return.

By my count, there is only one year that was +1% or -1% from the long-term CAGR, which was 1993.  Hell, make that a 3% band and you still only get about 7 or 8 years, depending on how you round off trailing digits.

As you can see, this is not a normal distribution by any stretch of the imagination.  

As such, when you see the annual forecasts come out toward the end of this year, feel free to snicker when you see people project that we will see the long-term average rate of return. 

How do I value stocks anyway? Part 2

This will be relatively brief as a follow-up to the previous discussion and it will predominantly focus on a particular part of how price to earnings ratios (PEs) are used to value stocks. I will confess that I have not read a finance textbook in some time so the following is more what I have observed and what economic theory would dictate than any particular theory that is widely accepted.

When you look at a stock quote page on any website such as Bloomberg, Yahoo! Finance, Marketwatch, or whatever brokerage account you use, you will see an estimate of the company's PE ratio. More often than not, this is based on the earnings per share for the prior one year as reported on a GAAP basis. Often when you hear an analyst on TV talking about a stock that they like, they will either use this prior one year number or use analyst estimates of the next fiscal year. Either way, it is almost always a one year snapshot. The market in general is usually somewhere between 10 and 20 times earnings, though individual companies vary widely.

Now, you might be asking yourself "Why would I pay 10-20 times a year's worth of earnings for a company?". This, on its face, is a good question. It does seem a bit absurd. However, implicit in our acceptance of any given PE ratio is the assumption that the current year's earnings per share are a good point for estimating future years' earnings. Indeed, stocks, more or less, conform to the discounted future earnings (or the related dividends and cash flows) of a company over a number of years. Take a current year's earnings, grow them at 8% per year, appropriately discount them for inflation or a risk free rate of return (people do both), sum up, say, 10 years and you get a number that makes considerably more theoretical sense.

Now, some interesting implications of this can be found in real life examples. Take Bristol-Myers Squibb (BMY) for a moment. In 2000, it traded at about 25 times earnings, which was not absurd given its growth rate in the 1990s. This was true of nearly all pharmaceutical stocks. However, collectively, their pipelines dried up and their patents expired, leading to earnings stagnation. Despite having a reasonable PE often around 13-17 times current year earnings, the stock first plunged and then simply faltered. This was repeated across the pharmaceutical industry.

Many analysts routinely mentioned the low PE ratios of the pharmaceutical companies as being a cause to buy these stocks under the assumption that they were now underpriced. However, the only thing that makes a PE ratio of 15 or so reasonable is if that company is going to be growing earnings over the next decade by at least 7% a year. In the case of BMY, you can see in the lower panel of that chart that they have had no earnings growth for a long time. Hence, the stock has fallen well off its highs and continues to languish.

Of course, the same thing happens the other way too. Seemingly unreasonable PEs like Google's (GOOG) can be made reasonable by truly extraordinary growth rates. A company can trade at 60x earnings if it is about to grow 35% a year or more for five years straight.

Another implication of this concept is when a company is poised to have an explosive year due to a big one-time payment or government contract. It may have a very low PE ratio due to these artificially expanded earnings. However, it will be a rude surprise for you indeed if you buy based on that and the company's earnings return to earth a few years later 80% below that inflated level. The discounted sum of its earnings over ten years (or whatever interval you choose) will be far less than you might expect.

This actually also relates to my prior post on bad trend analysis. You have to do more homework than just extrapolating out the past five years' average growth rate over the next decade for a company. You need to do good qualitative analysis to determine whether or not that makes sense or else using a particular PE as a rationale for purchasing a stock will not be fruitful.

A good source for tracking changes in earnings estimates

Earnings estimates for companies change just about all of the time, at least for large, widely held companies. It's often hard to get a good sense of how these estimates are changing. One good source to track these changes on a daily basis is on NASDAQ.com. You can see what estimates have changed for the current quarter, the next quarter, current fiscal year, and next fiscal year.

If you need to get a sense of how the direction of estimates has been changing in recent quarters, I know that a lot of brokerage sites have analysis tools that help you do that. Alternatively, there are sites like Yahoo! Finance that show very much the same thing.

Now, what is the usefulness of analyst estimates? That's an entirely different matter.