One thing for investors consulting historical data to remember is we may have had fundamental changes in stock valuations over the decades (and I suspect they have). Just to over simplify the idea if lets say the market valued the average stock at a PE of 11 and everyone found stocks a wonderful investment. And so more and more people buy stocks and with everyone finding stocks wonderful they keep buying and after awhile the market is valuing the average stock at a PE of 14.

Within the market there is tons of variation those things of course are not nearly that simple, but the idea I think holds. Well if you look back at historical data the returns will include the adjustment of going from a PE of 11 to a PE of 14. Now maybe the new few decades would adjust from PE of 14 to PE of 17 but maybe not. At some point that fundamental re-adjustment will stop.

And therefore future returns would be expected to be lower than historically due to this one factor. Now maybe other factors will increase returns to compensate but if not the historical returns may well provide an overly optimistic view.

And if there is a short term bubble that lets say pushes the PR to 16 while the “fair” long term value is 14, then there will be a negative impact on the returns going forward bringing the PE from 16 to 14. That isn’t necessarily a drop (though it could be) in stock prices, it could just be very slow increases as earning growth slowly pushes PE back to 14.

Another thing to consider is another long term macro-economic factor may also be giving long term historical returns an extra boost. The type of economic growth from the end of World War I to 1973 (just to pick a specific time, there was a big economic slowdown after OPEC drastically increased the price of oil). While that period includes the great depression and World War II, which massively distorts figures, from the end of WW I through the 1960s Europe and the USA went through an amazing amount of economic growth.

During that period the boom in communications, electricity, industrialization, air conditioning, modern farming practices (which continues booming significantly after 1973) indoor plumbing… increased the economy dramatically. We have had a subsequent period of massive boom related to computerization and software advances and health care drugs and technology. And Japan was a bit offset booming from 1950 to about 1990. And China has been booming from about 1990 to now.

While we may see similar boom, perhaps from robotics and continuing with health care technologies and perhaps India, Africa and South America could boom in massive globally macro-economicly significant ways. But it also is possible these huge macro-economic booms are not repeated. If so, it is natural that the historical stock market return would be reduced.

To a lessor extent financial engineering that was wise and useful, as apposed to just reckless gambling has boosted stock returns significantly. It is likely that won’t be repeated.

I like the idea of paying attention to long term historical data. And that has value for stock investors. But when you look at long term data you have to consider whether that data is not just providing measurements of what stock market performance can be expected to be (as say you would from testing scientific facts such as the boiling point of water). The historical stock data was true for a period of time and informs us about that period. But the next 40 years will be much different and to what extent the past data is relevant is open for debate.

Related: Global Stock Market Capitalization from 2000 to 2012 – Misuse of Statistics, Mania in Financial Markets – Are Stocks Still Overpriced? (2008) – Data Can’t Lie, But People Can Be Mislead – Investing Return Guesses While Planning for Retirement – S&P 500 Dividend Yield Tops Bond Yield: First Time Since 1958 (2008)

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