There are bumps along the way in the investment returns earned by our business corporations.  Sometimes, as in the Great Depression of the early 1930s, these bumps are large.  But we get over them.  So, if you stand back from the chart and squint your eyes, the trend of business fundamentals looks almost like a straight line sloping gently upward, and those periodic bumps are barely visible.

Stock market returns sometimes get well ahead of business fundamentals (as in the late 1920s, and the early 1970s, the late 1990s).  But it has been only a matter of time until, as if drawn by a magnet, they soon returns, although often only falling well behind for a time (as in the mid-1940s, the late 1970s, the 2003 market lows).

In our foolish focus on the short-term stock market distractions of the moment, we too, often overlook this long history.  We ignore that when the returns on stocks depart materially from the long-term norm, it is rarely because of the economics of investing, the earnings growth and dividends yields of our corporations.  Rather, the reason that annual stock returns are so  volatile is largely because of the emotions of investing.

We can measure these emotions by the price/earnings (P/E) ratio, which measures the number of dollars investors are willing to pay for each dollar of earnings.  As investor confidence waxes and wanes, P/E multiples rise and fall.  When greed holds sway, we see very high P/Es.  When hope prevails, P/Es are moderate.  When fear is in the saddle, P/Es are very low.  Back and forth, over and over again, swings in the emotions of investors momentarily derail the steady long-range upward trend in the economics of investing.

While the prices we pay for stocks often lose touch with the reality of corporate values, in the long run, reality rules.  So, while investors seem to intuitively accept that the past is inevitably prologue to the future, any past stock market returns that have included a high speculative stock return component are a deeply flawed guide to what lies ahead.  To understand why past returns do not foretell the future, we need only to heed the words of the great British economist John Maynard Keynes, written 70 years ago: "It is dangerous to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was."

But if we can distinguish the reasons the past was what it was, then we can establish reasonable expectations about the future.  Keyness helped us make this distinction by pointing out that state of long-term expectation for stocks is a combination of enterprise ("forecasting the prospective yield of assets over their whole life") and speculation ("forecasting the psychology of the market").

Author : John C. Bogle - The Little Book of Common Sense Investing

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