Over the long haul, the two primary drivers of stock investment return are Become a Complete Fool
1) Stock Earnings/Dividends
2) Stock Earnings/Dividends Growth Rate
At any given time, fundamentally, a 'good' price for a stock depends on the quality and quantity of two factors above plus the current interest rates and outlook for rates.
The higher current earnings/dividends, the higher the justified price of the stock. The higher the earnings/dividends growth rate, the higher the justified price of the stock. The lower the interest rate and interest rate outlook, the higher the justified price of the stock.
When interest rates were sky-high and U.S. treasury bonds yielded 13%, stock prices were depressed significantly because the (essentially) riskless alternative had such a high return. Of course, the high treasury yields had to do with the lousy inflation rates at the time, but that is starting to drift too far off track for this post. To allow the market to find a fair price for stocks, stock values had to drop significantly to allow their Total Shareholder Returns (current earnings/dividend yield + earnings/dividend growth rate, which drives stock growth rate) to exceed that of the (essentially) riskless alternative of treasury bonds. That is to be expected, because he risk/reward tradeoff dictates that investors will require a higher potential reward to take on the larger risk involved in investing in private businesses.
The same U.S. treasury bonds that 20 years ago yielded 13% today yield about 5-6%. The (essentially) riskless alternative has a much lower interest rate today than it did then, meaning that fair values for stocks are necessarily higher today than they were then, holding current earnings/dividends and earnings/dividends growth constant.
Looking at a chart and saying "GE needs to drop to $20 to drop into historical territory" completely neglects the impact of interest rates and inflation, two critical pieces of the puzzle that drive current stock prices. Sure, GE -can- drop to $20, but to justify that drop on earnings/dividend, growth, and interest rate basis requires the interest rates on the (essentially) riskless U.S. Treasuries to skyrocket or GE's earnings/dividends values, growth, or their respective quality to falter. If any of those things happen, I'll notice the news, evaluate my new position, and decide whether to eat my losses and take my money elsewhere or to hold on for the hopes of a longer-term recovery.
At GE's current price, for my own personal calculations, I have an expected rate of total shareholder return that exceeds my expected rate of return in the (essentially) riskless market of U.S. treasuries. I also know that, at GE's current price, a dollar invested in GE stock represents more in earnings and dividends than a dollar invested in the S&P 500. And in my opinion, that margin of return over treasuries plus that relative value over the S&P 500 provides sufficient excess return for me to justify my investment in the riskier instrument known as GE common stock.
A market is made up of willing buyers and willing sellers. That people are selling GE at this price, expecting it to go lower is a wonderful thing! That makes a market for the buyers, who are expecting it to go higher. As I've stated before, I personally believe that this is a fairly valued price for GE stock. My GE investment is in the tax-free shelter of my Roth IRA. If I'm wrong on the downside, I still have more 'income' from GE's dividends than I would have from the money market fund that my cash had been sitting in, previously. If I'm right on the money, then I'll enjoy moderate capital gains as the company continues to grow earnings and dividends (thereby driving the stock price upwards) to go along with my superior yield. If I underestimated GE's value, then I'll enjoy superior capital gains to compensate for the diminishing yield associated with a 'recovering' stock.
I fully admit, when I hear technical analysts talk about how such-and-such a pattern indicates further weakness, or how XYZ should rebound nicely because of the underarms-and-toilet-bowl shape of its chart, my eyes glaze over. I tried daytrading with fake money, and I found that I was no good at it at all. The 'obvious' patterns had already broken down by the time I got around to noticing and acting upon them, and I frequently guessed wrong with the 'emerging' patterns.
So, I'll stick with what I know. I'll read the 'boring' parts of the annual reports and crunch numbers based on the figures presented there. I'll go to FreeEDGAR to look up older SEC filings. (Their GE stuff goes back to about 1994). I'll trust that Andersen's conviction and implosion on the obstruction of justice case will assure that auditors will be scared straight when it comes to screwball accounting, at least for a long while. I'll sniff around the news feeds and archives to see if any recent big news may change the course of a company I am considering. I'll look backwards to see how consistent earnings and dividends have been and how their growth is projected to be in the future. I'll look at all the data and projections, take a gander at the management team and figure out how much I trust it, and then, if everything lines up and the stock price indicates a good value to me, I'll make an investment.
Once in a while, I may get it wrong and lose. Once in a while, I may find a diamond in the rough and get some stellar short-term gains. Over the long haul, and in the aggregate, however, I expect to get solid, long-term, positive returns. I hope to beat the market, long-term, but if I can't, I expect to still be okay, anyway.
The act of saving money customizes my lifestyle to help me live below my means. The act of saving money reduces the necessary additional sacrifice that I will have to make, once I start a family and have children and their futures to think about. In that future, my personal savings rate can then drop and that money can go towards my family, with no appreciable loss in my lifestyle or outrageous belt tightening. The act of saving money also directly builds my nest egg, so that when my earning years stop (likely due to age, excessive wealth (don't I wish!), chronic unemployment, or disability), I will have enough to live.
If my savings can be prudently invested at a rate better than that of (essentially) riskless bonds, then all the less I will have to worry and/or save to have that nest egg become golden. If my savings can be prudently invested and still somehow manage to beat the stock market indices, then my research and reading will really be time well spent.
In the mean time, I'll do a little up-front research on the companies of which I am looking to purchase shares, buy if and when the prices seem properly valued to me, and check back, from time to time, to make sure the companies I'm investing in still represent the good, long term values that I believed they represented when I purchased them.
When I bought my shares of GE a couple of weeks ago, I thought they represented a good value for me at their then-current price. I've slept quite well since then. Today (pulling out a chart), GE flirted both higher and lower than my original purchase price. It has been doing that quite regularly since I put my money into it. Were I a daytrader with perfect foresight, I -guess- I could have made some money playing the gyrations above and below that price. Since I do not possess that foresight, I'll take the day to day and minute to minute gyrations in stride.
Instead of stressing that my GE investment is currently down a couple of cents and has gone almost nowhere in about half a month, I have much better things to do. This evening, I have a date. I'll go out to dinner with a lovely young lady. Then, I'll take her to the Broadway musical that is touring through town. I plan to have an enjoyable evening, and I hope she does, as well. The management of the companies that I have invested in can take care of running their businesses all by themselves. I trust that, in the aggregate (GE included), they will do well by me, and that in the long haul, the time value of money and the amazing power of compounding will allow me to live comfortably.
Your mileage may vary, your expectations may differ, and your future may diverge from mine. You are free to do whatever legal things you would like with your money. I may even be living in a fantasyland where only I believe that things like earnings, dividends, growth, and expected rates of return matter. Until the data proves otherwise, beyond a short term blip that I can easily dismiss as noise, I'll continue to stay there, however, and enjoy my journey.
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.
Over the long haul, the two primary drivers of stock investment return are
Become a Complete Fool