In one of my recent posts I made the argument that the stock market is not gambling if you use a diversified basket of stocks and chose to invest in the overall market. In that post, I used a graphic of the S&P 500 which showed that over the course of decades the S&P 500, which is often a proxy for the overall market, has increased. The logical question for the prudent investor is then: Why is this the case?
I admit I struggled with this idea for a longtime. As a person who has a pseudo-efficient market mindset, believing that the market will generally go up over time is very important to me. After all, if it didn’t, then investing in index mutual funds and ETF’s would ultimately prove to be a losing proposition.
After thinking about this for many years, I have come up with 5 reasons why I believe the market continues to go up over time. Two of these are what I would call fundamental arguments (laws of nature type stuff) while the others are technical and due to the current ways our society works.
Everyone understands that something of value usually comes with a price tag. If you want a new phone, it’s going to cost you money. Lunch at your favorite restaurant, more money. Everything from daily needs to our discretionary items has an associated cost. Why is this the case?
One of the most fundamental laws in the field of microeconomics is supply and demand.
The chart above describes this law pictorially. The downward-sloping line represents demand while the upward-sloping line represents supply for a given item people buy. The point at which these two lines cross, is the price of the item that will exist at your mall, supermarket or wherever this item is sold (also called equilibrium price).
This chart has some interesting features. If there is more demand for a product, the demand line moves up vertically and the market price of the item increases. Similarly, if the supply of a given item decreases, the supply line moves up vertically and the market price of the item increases as well.
So, what increases demand? More people. With a growing global population more people will be buying items everyone wants which drives up demand.
What decreases supply? In the long term the limited natural resources we have on earth will drive decreases in supply which will raise market prices. The one natural resource that will likely not be replaced with technological innovation I am talking about is land.
For example, there is only so much land to grow crops and build houses. Land also contains current commodities we rely on including lithium for batteries and oil for gasoline. These long-term supply limits provide a long-term driver for higher market prices for items we buy today.
So, what is the connection between higher prices for items and an increasing stock market? The answer to that question involves dividends and earnings-per-share (EPS).
The only real reason to own a stock is due to dividends or the potential for future dividends. You might be confused by this statement, but it is absolutely true. Think about a company stock offering where they swore they would NEVER offer dividends for shareholders. Why would you own this stock? If there is never a chance to make any money off of company ownership you might as well buy a napkin, put the company name on it and call it equally as good as the stock certificate itself. Stock ownership has no intrinsic value. Dividends or future dividends is what gives stocks value and drives capital gains in stock prices. This is a critical thing to realize as an investor.
Now that we understand this, you must understand the connection between EPS and dividends. If earnings are higher via supply and demand changes, then more money is available to pay out dividends. If more money is given in dividends, then stock prices will increase as stocks become more “valuable” to own.
As technology continues to improve over time our manufacturing processes will continue to improve in efficiency. Think about robots being used building cars and airplanes, new tractors making harvesting crops easier and artificial intelligence making production processes smarter in general. All these things will make production costs decrease which will increase company earnings and thus dividends. If this is confusing just remember that earnings have two components.
Technological improvements act on the expense portion of this equation while supply and demand do more to the revenue.
Anyone that works for a company which provides a retirement savings plan understands the push towards stocks in retirement investing. Pensions are slowly being eliminated everywhere which is furthering this push towards buying stocks to fund retirement in our society. This societal structure provides automatic buyers into our stock market.
If you look at list of the top 100 richest people in the United States nearly all of them will have some exposure to stocks in our stock market. In most cases they are heavily invested in the stock market. Whether you agree with it or not, these people have more sway, via lobbying using their money, in influencing the direction of our laws. In general, they will use this influential power to make laws which improve stock market conditions and increase their overall wealth. If you have money in the market you can benefit from this power as well.
Historically the Federal Reserve Board (Fed) of the United States targets a small percentage of inflation in goods and services through its control of interest rates. Over time, this inflation compounds and leads to larger increases in prices for goods and services. If you want to see this effect just look at the price of anything 60 years ago.
As prices increase, companies’ EPS grow and thus dividends and stock prices increase as well. This leads to a generally increasing stock market valuation.
As with any argument I’m sure there are counter arguments to what I have presented here. If you disagree please feel free to email me or Tweet me @smartmoneymath. Hopefully what I described makes sense and helps paint a clearer picture why the stock market continues to go up over time.