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The stock market: It’s something that seems easy to understand. But it rarely acts the way you expect—and that’s true for everyone, including seasoned investors.
That’s because the way the stock market works has fundamentally changed over the years. And while the recent bull market has allowed industry and business leaders to ignore dangerous shifts, economic uncertainty has highlighted the many issues with recent market behavior.
In particular, many investors question the future of the market amid high-interest rates, bank closures, and inflationary pressures.
Can investors count on 18% or 30% returns every year going forward? Or will the market crash spectacularly?
It’s impossible to accurately forecast actual returns. But I do feel that we’ll likely return to a “real market.”
Before we talk about what that means, let’s look at the recent bull run, the historical returns, and how the stock market really works today.
On the heels of one of the country’s worst financial crises, the stock market experienced astronomical growth. In fact, the last decade has been one of the best periods in the stock market’s 140-year history. Even after a monumental drop at the end of 2018, the rapid rebound restored investor confidence.
What happened?
Some experts and financial institutions point to monetary policies like qualitative easing, where the government buys assets like bonds to stimulate the economy. Others credit tax cuts.
Skeptics point to the separation of the stock market from the economy, with financial institutions largely driving growth through high-frequency trading and higher fees.
Whichever side you trust, the fact is that the United States has experienced a bull market for around 15 years.
There is one problem. What goes up must eventually come down. But what does that mean for investors–those looking to build wealth, save for retirement, or leave a legacy?
To get an idea, let’s first review the historic gains of the stock market and compare them to the recent and wild gains.
Let’s take a look at how the market has historically behaved over the last 80 years until 2020 for the S&P 500. Why did we choose this index fund? The S&P 500 is commonly considered to be a benchmark for the overall economy and individual investment portfolios.
Looking at the numbers, we can begin to understand how widely volatile the market has become. After the 2008 Financial Crisis, we can see that the stock market returns increased dramatically from previous years. But the last 15 years have been a whirlwind of massive gains (and losses).
Let’s look at the individual average returns for the S&P 500 for every year from 2005 to 2020:
From these annual return numbers, we can see that the S&P started to return more than double the rate from 2005 in most years. Outside of 2008, the few negative returns were minimal and were eclipsed by the next year’s gains.
In other words, the market skyrocketed. Prices outpaced value.
And this is before we consider the high of the pandemic in 2021 when the returns were 28.7% — despite inflationary pressures and the widespread lockdowns.
In fact, the S&P saw more lavish returns over the last fifteen years than losses. The only sizable loss was in 2008, with a drop of 35.63% in value. But the market began to recover within a year. The remaining market losses in 2015 and 2019 resemble blips compared to the annual gains.
The reason for this market boom becomes obfuscated when we look at the devaluation of the dollar.
We looked at the average changes in purchasing power through the Consumer Price Index (CPI), which shows the changes in consumer prices over time and is often used to interpret inflation. In particular, we’ll look at the average equivalent to $10 in 2020 across different periods:
So, what can we get out of these numbers?
We want to focus on inflation and compare that to the average returns. Let’s consider the years between 2005-2020 once again.
It was only in the last five years that the stock market beat out the average inflation rate. And that trend likely won’t last.
To sum all this up, the investors made more than ever in the current market. This bullish streak, which began in 2009 and stretched over a decade, was the longest in United States history. But it wasn’t enough to outrun inflation and decreases in buying power.
But what changed in the market that created such fabulous, short-term returns—and why won’t it keep working?
Back in the 1930s and 1940s, trading in the stock market was a tangible, real event. It wasn’t quite a free market, but stock prices were linked to a company’s value. If you bought a General Motors share, for example, you would feel comfortable knowing that it was the same valuation at every exchange.
That emphasis on value eroded over time. The focus shifted from individual investors to high-frequency traders.
The United States stock market as we know it today originated in 1792, and it’s continued to adapt to new technologies and regulations. But one of the most influential changes in today’s market occurred in 2005–and experts say that it's broken the market.
Professor of International Political Economy at Oxford, Walter Mattli, highlights in his book Darkness by Design that the powers that rule the stock market have changed. The current trading system is continuous—meaning that trades are executed in a manner of microseconds. But it’s not an organic trade, with sellers and buyers getting matched up and deciding on a price.
All prices are decided by an algorithm. This allows deals to be executed rapidly. The trade-off is that the value of the company is no longer linked to the price in the short term. Sure, over 6-12 months, you may be able to estimate the real price of a stock. But it’s distorted by high-frequency trading tactics.
Let’s look at an example.
Theoretically, a stock will sell for the same price across exchanges. In reality, what Platform A is selling General Motors stock for may differ from Platform B by a minuscule amount—maybe just a few cents.
With today’s technology, traders realize they can buy the GM stock for less on Platform A and then sell it for more on Platform B.
You may think that a few pennies aren’t worth much. But imagine selling 100 million shares.
So if GM is selling for $100.50 on Platform A, and a trader sells 100 million of these shares on Platform B for $100.55, they’ve made a lot of money. That’s $5 million dollars. And the trade only took a few minutes, at most.
This system isn’t unique to the United States, and it has been shown to be a detriment to investors. Exchanges operating on this model may have a higher volume of trades, but they also accumulate higher fees and higher profits—none of which is positive for investors looking to grow their wealth or save for retirement.
This is a far cry from the traditional idea of the stock market. The original stock market allowed investors to buy and sell shares from companies, with well-performing stocks indicating the company’s financial strength and investor confidence.
And this distortion comes at a price.
The current form of buying and selling tactic pumps up stock prices and decreases the value of dividends. Eventually, the stocks will hit a price where very few people can afford them.
Eventually, the price will start to drop as a result, and two things will happen. First, investors who bought the stock at an overinflated price will lose out on value. If they sell, they’ll sell at a loss. Secondly, as more stock prices hit the ceiling of affordability, the market will begin to average out. We will see this behavior across the market, meaning more losses in the short-term and fewer gains in the long term.
This process is very similar to what happened with the Dot-com Bubble in the 1990s. It’s a market cycle that has been around longer than the United States has been a country. The most well-known example is “Tulip Mania” — when the price of tulips skyrocketed between 1636-1637 in the Netherlands. The price could be more than 10 times what the bulbs cost a year before. And while this bubble burst only a year later, it had lingering effects on the Dutch economy.
The past decade has seen significant growth for these organizations and some investors riding the wave. However, waves do eventually reach the shoreline and crash.
At this point, we’re likely to see a return to a more average market. There will be fewer enormous gains to level out negligible losses. In fact, losses may return to higher levels as well.
The question will be how the market will fare once it returns to a more normal financial cycle and whether the current weakened foundations can sustain the inevitable change. Inflation, stagnant wages, and macroeconomic trends all contribute to a bearish cycle.
This return to muted market returns, for those saving for retirement or focusing on wealth preservation, highlights the importance of revisiting your portfolio and investing strategy.
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