How to Win With Stocks

I included the following chart as a part of a longer article two weeks ago, but I think its descriptive power is sufficiently (i.e., extremely) important to discuss on its own. It demonstrates to me one of the most important keys to successful investing.

At first glance, this may look like a lot of gobbledygook, so let me explain. The chart compares the growth of three variables since 1950: gross domestic product, corporate earnings, and the Dow Jones Industrial Average (DJINDICES: ^DJI  ) -- you could include the S&P 500 (SNPINDEX: ^GSPC  ) and the results would be analogous. To normalize for the difference in numbers, I converted the figures into an index, setting the year 1950 equal to 100, and controlled for inflation. By doing so, we can cleanly and meaningfully see the relationship between the figures.

So what does the chart tell us?

It illustrates the indelible correlation among GDP, corporate profits, and the Dow. To many of you, this won't be a surprise, as it makes sense that a higher GDP would result in higher corporate profits and vice versa. And taking it one step further, because stock valuations are a function of earnings (thus, the P/E ratio), the connection between corporate profits and the Dow (and thus GDP and the Dow) should be obvious as well.

Now to the interesting part: While there's a clear long-term relationship between these variables, there are also significant short-term deviations. This is particularly true when you compare the Dow's performance to GDP.

Speaking generally, there are three distinct time periods here. The first is from 1953 until 1972, when the performance of stocks outpaced GDP growth. The second is from 1973 until 1996, when stocks underperformed national output. And the third is from 1996 until the present, when, with the exception of the financial crisis and subsequent recession, stocks again outperformed GDP.

There are innumerable takeaways, but the most obvious is a sort of mean reversion. That is, when the Dow has either under- or overperformed GDP, the relationship is bound to correct itself. Following the "go-go years" of the 1960s came the crash of 1973-74, recession, and stagflation, all of which exerted a downward influence on blue-chip stock prices relative to GDP. This trend reversed itself beginning with the great bull market of 1982, which lasted until the Internet and housing bubbles successively popped.

So what does this mean for investors? To me, this chart reveals the roadmap for a successful investment strategy. Assuming GDP grows at 2% to 3%, your investment portfolio could as well, simply by investing in the SPDR S&P 500 (NYSEMKT: SPY  ) ETF. Want to juice those returns? Go instead for the SPDR S&P Dividend ETF (NYSEMKT: SDY  ) , which tracks the S&P High-Yield Dividend Aristocrats Index. And in purchasing these, to control for the variations, it'd be prudent to use dollar-cost averaging -- that is, buying the same dollar amount of the index each month or year come rain or shine.

At the end of the day, it's nice to think that picking individual stocks is the best way to beat the market. But the reality is that most stock-picking strategies will lead to suboptimal performance relative to the market, if not absolute losses. Over the long run, keeping it simple is the way to win with stocks.

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