What Causes Stocks to Grow?

The author of the article, Vladimír Jurík, is a tied investment agent of Finax, a finance blogger, and the author of a great educational project Peniaze sú čas.

Stocks constantly grow. This has been a fact for hundreds of years.
 

Source: Macrotrends

Despite all this, there are still people who label it a scam. Ponzi’s scheme. A casino, where only the few chosen ones win, and the rest lose it all.

Central banks manipulate everything with their evil money. Everything would collapse like a house of cards if it weren’t for money printing, government debt, exploitation, and power abuse.

Of course, stocks don't have to grow every day, month, year, or five years. However, to think that the profits of stock markets are fake, made-up, manipulated or that they are only a big bubble is just nonsense.

Let’s take a closer look.

Is It All a Scam?

Investors‘ main motivation behind buying stocks is (for the purposes of this paragraph, I’ll also add "allegedly") to take part in the profits of companies. The higher the anticipated profit, the more investors are willing to pay for that particular stock, (again, for the purpose of this paragraph, I’ll add “theoretically”).

In his book Don’t Count on It!, a pioneer of index investing and the founder of Vanguard, John Bogle, describes three forces that drive the prices of stocks up:

Expected return = current dividend yield + growth in profitability + change of the PE ratio

It is a simple formula, but, historically, it has worked relatively well.

What does the PE ratio mean? It is a ratio between the price of a share (P) and earnings per share (E). The more investors are willing to pay for 1 dollar of profit, the higher the PE ratio is.

If it were true that the growth of stock prices is not backed by anything and that people mindlessly pour money into them in hopes of selling them to an even bigger lunatic for a greater price, then this indicator would continuously grow. And it would grow at the same pace as the stock market.

Is that the case?

Source: A. Damodaran

Despite its mild growth, the PE development doesn’t show any trend, as can be observed from the graph. Its average value since 1960 was 16.97, the average during the last 25 years is 20. During 2023 it has reached 21.69 which is a little over the long-term average.

So, let’s compare the PE development with the growth of stocks (both time series are normalized to 1960, in which they have the value of 1):

 Source: A. Damodaran

I believe that we can be almost 100% sure that the growth of the S&P 500 index doesn’t correspond with the growth of the PE ratio, making this factor unable to be the force driving its growth.

So, it is not a scam. But why do stocks keep growing then?

Is It Driven by Dividends?

The second factor mentioned by J. Bogle is dividends, so cash actually paid out to the shareholders. In principle, it makes sense – if we invest to generate profit, very few things are better than „cold hard cash“ poured straight into our pockets. 

What about the data?

Source: A. Damodaran

The graph illustrates that the dividend growth is correlated to the growth of stock prices. Especially until 1993, after which the relation mildly crumbles.

1993/1994 drop in payout ratio (percentage of profits paid out to investors as dividends) is the reason behind this breaking point. Although dividends are more stable when compared to profits, there are strong linkages between these variables – a firm cannot pay out dividends if it doesn’t have earnings and cash flow to pay it out from.

That’s why dividends act as a force behind the growth of stock prices pretty well even today.

But we still have something better up in our sleeve.

The Main Cause of Stock-Price Growth Is the Growth of Profits

The part above already implies it, but just to make sure, let’s take a look at the last factor mentioned by J. Bogle – the growth of profits (better to see once than hear a thousand times):

Source: A. Damodaran

Clearly, the growth of corporate earnings describes the stock price growth the best. And we’re not bound to just look – the correlation between these two time series is 97.5. 

Nothing is perfect, of course – stock prices break the ceiling sometimes, and sometimes their growth lags behind profitability. These differences can be explained by investors’ emotions – also known as fear and greed.  

The data should serve as stress relief to every long-term investor – stock markets are neither a casino nor a pyramid scheme. The best explanation of why stocks grow is because the profits of companies grow as well.

Of course, the prices will always be more volatile when compared to profitability development in the short run, for they are influenced by a much greater number of factors.

However, fundamentals (especially profitability) always win in the long run.

What I Wrote on ‘em Socials 

Here’s a pretty cool post from my social media which I believe would be pity if you didn’t see:

Since the beginning of the year, a certain bad habit has spread among investment professionals here - claiming that although stocks are rising, it's driven only by 3 (or possibly 1, or 4, there are different versions) companies and that's bad, and a disaster will come and so on.

Well.

Since the beginning of the year, Nvidia has grown by 87 % (everything in US dollars). Wow! Is that sustainable? Likely not.

Since the beginning of the year, Meta has grown by 45 %. Wow! Is that sustainable? Likely not.

Since the beginning of the year, Netflix has grown by 25 %. Amazon by 16 %. Microsoft by 9 %. The total return of the entire S&P 500 index from the beginning of the year is 8 %. Amazing!

However, is it only thanks to the 5 companies stated above? Or, perhaps, thanks to the Magnificent 7?

No, it is not.

Since the beginning of the year, Google has dropped by 4 %. Apple is down by 12 % and Tesla has dropped by wonderful 28 %. Despite this, the index experienced a great start to the year, and it is not thanks to just 3 overhyped companies or thanks to the AI craze.

This is a highly popular but false narrative.

Source: Charlie Bilello

Costco (something like an American version of Tesco) has grown by 10% since the beginning of the year, and that is after a solid correction. Eli Lilly (a US drug manufacturer) went up by an incredible 27% since the beginning of the year!

An even more stunning view is provided by the version of the S&P 500 index where all the companies have the same weight. It has achieved a return of 5% since the beginning of the year, which is less than an index weighted by the market capitalization, but not by much. This goes to show that growth occurs across the market, not just in a few selected titles.

And this doesn’t apply to large companies only. US mid-cap companies (for example, the S&P 500 Mid Cap 400 index) have grown by nearly 6% since the beginning of the year.

EU large-company index earned 5.15%. Japanese stocks (!) advanced by more than 8% this year.  

Small and emerging markets (where China is the biggest problem, the rest of the markets are in a good situation) are also doing well. Maybe not as significantly, but still pretty well. 

So, the current growth of stock markets is not concentrated in a few fashionable companies. It applies to a very broad specter of a growing number of individual companies and different segments. Technically speaking, there is “market breadth” in the current growth.

The main drivers are growing profits, which historically signals good news for the stock market's future development.  

All we’re talking about are probabilities, and nobody guarantees anything. Can a correction come? Sure, it can. Bear market, God forbid? Even that can happen. Is Nvidia overhyped? Most likely.

However, global stock markets are in a very good condition, and if your allocations are well set (according to your ability and will to deal with risk (volatility), all while being diversified enough), there’s no need to panic and make mindless decisions regarding your portfolio.