No. of Recommendations: 35
There is a wonderful paper, published by a Fed person in June I believe, entitled
"End of an era: The coming long-run slowdown in corporate profit growth and stock returns"https://www.federalreserve.gov/econres/feds/end-of...I think anyone interested in the likely returns from the broad US market in the next decade or two should read it.
Not that it has all the answers, but it has a lot of information that all such planners should know.
TL;DR - don't extrapolate results from the last 30 years. We all did well because profits soared because of one-time falls in interest costs and taxes.
A couple of snippets [emphasis mine]
From the abstract:
"I show that the decline in interest rates and corporate tax rates over the past three decades accounts
for the majority of the period’s exceptional stock market performance. Lower interest expenses
and corporate tax rates mechanically explain over 40 percent of the real growth in corporate profits
from 1989 to 2019."From early in the paper:
"I first consider corporate profits. From 1989 to 2019, real corporate profits grew at the robust rate
of 3.8 percent per year. This was almost double the pace seen from 1962 to 1989. The difference
in profit growth between these two periods is entirely due to the decline in interest and corporate
tax rates from 1989 to 2019. One way to see this is to compare the growth of earnings before
subtracting interest and tax expenses (EBIT). In fact, real EBIT growth was slightly lower from
1989 to 2019 compared to 1962 to 1989: 2.2 percent versus 2.4 percent per year.And a bit later:
"[O]ver past thirty years, declining interest and corporate tax rates
can explain much of the realized equity premium. In my sample, the realized equity premium for
the period 1989 to 2019 was 7.2 percent per year, compared to 3.6 percent for the years 1962 to
1989. Higher risk is an unlikely explanation for the return difference. Indeed, stock price
volatility was lower during 1989 to 2019 than it was during 1962 to 1989.
Rather, the decline in interest and corporate tax rates can explain the entirety of the performance
difference between the two periods."And, since it's always nice to include something original in a post rather than just a recommendation:
They paper uses EBIT to track results excluding (rather obviously) the costs of interest and tax that is the subject of the paper.
Another way to track results that gets much the same result is looking at sales. It's only a proxy, but quite a good one, and the data are more readily available.
The average price to sales ratio of the S&P 500 since January 200 has been 6.763.
That's using the S&P value on each month end, and the most recent known sales figure which is a bit older.
The equivalent figure today is 9.907. That's with the S&P at 4653.74 and most recent sales estimated (a bit of extrapolation) at 469.73.
So, if sales were to turn into profits at the same rate as the average so far this century (around the same operating margins, tax, and interest costs), the S&P 500 is 46.5% more expensive than the average valuation level seen since 2000. Interestingly, much of the high profit / low tax / low interest era is in that sample interval used as a baseline of "normal", not the old figures from 30+ years ago.
True, there are a few gigantic firms with very unusual economics--but that's a pretty big number to explain with "it's different this time" : )
Especially given the result of the paper, showing the faster rate of profits was *entirely* due to falls in interest costs and tax rates which can not be extrapolated.
For the geeks in the crowd, there is another interesting observation in the paper.
The EBIT of the S&P 500 consistently rises more slowly than GDP, both in old and new sample periods studied.
Jim
