The Stock Market Is Both a Voting and Weighing Machine

The Voting Machine

Day 1 of my investment studies delivered a seminal lesson. As Ben Graham wrote:

Initially, I did not fully appreciate that maxim, but over the years, I have realized its insight.

Graham’s first point is the difficulty of anticipating the opinion of the voting machine. Political forecasts are largely accurate because pollsters collect data. No such mechanism exists for the stock market—and if it did, its findings would be unreliable, because for equities, the sentiment clock constantly resets. Investment beliefs fluctuate far more readily than do political preferences.

The Voting Machine: Stocks Rally After Trump’s 2024 Win

This inconstancy leads to stock market behavior that is difficult to explain, even with the benefit of hindsight. Consider the performance of US equities following the election of Donald Trump, on Nov. 5, 2024. The following day, equity prices soared, kicking off what commentators termed “the Trump trade.”

One explanation for the monthlong rally is that investors preferred the president-elect’s business-first approach to Democratic policies. Now billionaires who know how to make money would be in charge, not career politicians. Another possibility is that voters weren’t necessarily celebrating Donald Trump’s triumph but were happy that this election, unlike its predecessor, was quickly settled.

The trouble with those claims—which have been widely believed—is that stocks rallied much further after the 2020 presidential election, when (1) the winner was indeed a career politician, (2) he defeated one of those billionaires who are said to be good for stock market prices, and (3) the outcome was unsettled for days. See the chart below that shows the first 45 trading days following each election.

That illustration, it must be confessed, proves nothing. It could be that investors were unhappy with Joe Biden’s victory or the wait for the election results but were so delighted about that era’s economic news that they bought stocks regardless. Perhaps, or perhaps not. Speculation about the voting machine’s judgment is just that—speculation. Your guess about how stocks will perform over the next few weeks or months is unlikely to be better (or worse) than mine.

The Weighing Machine: Stocks’ Long-Term Growth

In contrast, the weighing machine’s conclusions are easy to interpret. Stocks possess long-run value because they provide their owners either with (1) current cash, in the form of dividends, or (2) the potential to receive even more cash at a future date, by growing their earnings. Over time, then, stock prices will track corporate profits.

That is indeed what has occurred, albeit loosely. The next chart depicts two items. The first is the real growth of a $10,000 investment in the S&P 500 since February 1988—the date on which I first read Ben Graham’s words. (As a reminder, in investment terminology, “real” means “after inflation.”) The second is the performance that would have occurred if the index were stripped of its voting effects so that it provided solely the combination of (1) the ongoing dividends plus (2) the change in corporate profits.

(In other words, the second line fixes the S&P 500’s price/earnings multiple at its February 1988 level of 14.2. The blue line represents the total return to US equity investors, assuming stocks had retained that initial P/E ratio.)

How the Stock Market Incorporates Sentiment Changes

It may be objected that the stock market’s increase far exceeds the underlying growth of its companies! Fair enough; those lines are indeed widely separated because the price/earnings ratio for US equities doubled since the start of that period. The voting machine operates over extended periods, too.

As we have seen, though, equity shareholders needed no assistance to prosper. The key to their success was corporate America’s achievement. The rest was a bonus. The dividends that US companies paid, plus their increase in earnings, provided ample compensation for common-stock owners, no matter what the workings of the voting machine.

The same principle applies when looking forward. I do not expect the future to be so generous to shareholders. Today, US equities trade at a price/earnings ratio of 28, which is not only high by historical standards but also steep when compared with long-bond yields. Eventually, I expect the P/E ratios will retreat to the lower 20s, which would reduce the stock market’s total returns.

But that doesn’t change the argument for equities. If corporations continue to thrive—which, as I sketched out in my (somewhat) farewell column, there is every reason to expect that they will—their shares will continue to be fine long-term investments. Maybe their returns will only be good rather than glorious. That’s all right, too.

Out-of-Scope Investments

One might ask, what about bitcoin? After all, that asset has thrashed every rival in recent years, save for Caitlin Clark’s Gold Vinyl rookie card. Can Graham’s tenets explain that performance?

The answer: clearly not. The weighing machine has nothing to say about bitcoin, because it neither pays cash today nor ever can. The same precept applies to gold bullion, fine art, and pet rocks. That doesn’t mean that they lack value—the history of gold prices emphatically proves otherwise—but rather that Graham’s weighing machine cannot assess their worth.

Whether anybody else can is an open question. Commentators make bold forecasts about cashless assets, just as Charles Barkley does about NBA games, but their predictions strike me as equally (in)valid. Bitcoin will bitcoin, just as gold will gold, land will land, and fine art will fine art. I know not how and where those needles will land—and if somebody truly does, I know not how to find that person.

Which, no doubt, would also have been Mr. Graham’s answer.