Repeat After Me

IF YOUR INVESTMENTS CLIMB in value, hold the champagne—until you figure out whether it’s a onetime gain or a repeatable performance.

Suppose your foreign stocks post gains because the dollar weakens. Or your bonds climb because interest rates fall. Or stocks rise because price-earnings ratios head higher. Or corporate earnings increase because profit margins expand. Or stocks jump because the capital-gains tax rate is cut.

You won’t necessarily give back these gains—and, indeed, the dollar could weaken further, interest rates could drop even more, P/Es might rise yet higher, profit margins could widen further and tax rates might be cut again.

But each of these is a road you can only travel once. For instance, since the early 1980s, the yield on the 10-year Treasury note has fallen from roughly 16% to 2% and the S&P 500 has climbed from seven times earnings to 21 times earnings. Treasury yields can’t fall from 16% to 2% again and the S&P 500’s P/E can’t climb from seven to 21 again—unless we first saw a dramatic market reversal. In other words, these are truly onetime gains.

Moreover, in some of these cases, there are limits to how far these developments can run. Theoretically, the dollar could continuously weaken and P/Es could continuously rise, though neither seems likely and that certainly hasn’t happened historically. But interest rates are unlikely to spend prolonged periods below 0%, profits margins can’t expand so that all of GDP goes to corporate profits and taxes rates can’t be any lower than 0%.

So what would count as a repeatable investment performance? It’s reasonable to expect that bonds will continue to pay interest at their stated yield until they mature. It’s reasonable to expect that, over time, corporate earnings will rise and dividends will be paid. And that’s pretty much it.