Post New

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

That 46% figure is exactly the same as the Buffett indicator I checked last week.

I think anyone interested in the likely returns from the broad US market in the next decade or two should read it.

Are you seriously suggesting that people with a 10-year time horizon should avoid the stock market and read a pessimistic academic paper? Sorry, that's just bad advice. I'm telling my kids to do the same thing I did - put 10% of their paycheck into their 401Ks invested 100% in an S&P 500 index fund. Keep doing that throughout their working years. It's the only way they're going to beat inflation and reach their retirement goals.

We all did well because profits soared because of one-time falls in interest costs and taxes.

No, we all did well because we stayed fully invested at all times and didn't listen to pessimists whose predictions would always be wrong. They all sounded smart at the time. Only problem is that their multi-year "forecasts" were wrong.

I can easily refute the claim that our profits were due to "one-time falls in interest costs". Interest rates have risen to record highs this year. Mortgage rates used to be under 3%, they're now over 7%. Interest on the 10-year T-bill quintupled from under 1% in 2020 to almost 5% this year. And, yet, here we are with the Dow at a record high, the S&P 500 up 23% YTD and QQQ up a whopping 50% this year!

The opportunity cost of listening to pessimists would have been tremendously high, and would have contributed to the retirement crisis in America.

I can easily refute the claim that our profits were due to "one-time falls in interest costs". Interest rates have risen to record highs this year. Mortgage rates used to be under 3%, they're now over 7%. Interest on the 10-year T-bill quintupled from under 1% in 2020 to almost 5% this year. And, yet, here we are with the Dow at a record high, the S&P 500 up 23% YTD and QQQ up a whopping 50% this year!

Record high? I think you need a history lesson. Rates have returned to more normal levels from RECORD lows.

Tecmo

Are you seriously suggesting that people with a 10-year time horizon should avoid the stock market and read a pessimistic academic paper? Sorry, that's just bad advice. I'm telling my kids to do the same thing I did - put 10% of their paycheck into their 401Ks invested 100% in an S&P 500 index fund.

The numbers are pretty simple.
Ultimately, over the long run, the value of the broad cap-weight US stock market is going to track the after tax profits of that set of companies.
There will be times it's more expensive than usual relative to the entire stream of future profits, and times it isn't.
If you buy at a time that the valuation is extreme, your money will earn nothing for a long time. Potentially a very long time.
If you're fine with that being an inevitable corollary of your advice, and your kids know it too, then all power to you and your kids.

But a bit of context is important. Never mistake a cycle for a trend and extrapolate from a stretch that was unusually good.

History is usually a good instructor.
The real total return of the S&P 500 in the first decade of this century (end date smoothed) was -1.49%/year compounded, counting dividends.
The non-financial subset was trading at about 8.3 times trailing sales at the start of that stretch.
They're currently trading at 9.9 times trailing sales. So who would rationally expect a better outcome this time around?
So, unless you think a dollar of sales at the average firm indicates WAY more aggregate future profits than it used to, the medium term outlook for returns is bleak indeed.

The future is never certain. But you should always start your planning with a set of assumptions that is self-consistent and also consistent with the known data. Pick a likely growth rate for aggregate after-inflation US market sales over the next 10 or 20 years. Pick any number you believe for likely future gross margins, and corporate tax rates, and average interest costs as percent of EBIT. That research paper has a lot of data that would let you pick plausible or optimistic numbers for all those factors. From those assumptions, you have a rough estimate of future aggregate net profits. Slap on the multiple you think is likely, and you get a future level for the index. Add the current dividend yield. What rate of total return do you end up with? Is it the one you were expecting before you did that exercise?

Over the long run, net profit margins can't rise without limit: they can't rise faster than sales, or they would exceed sales at some point. And aggregate sales can't rise faster than the size of the economy the companies are embedded in. Non-financial S&P 500 sales have risen at only inflation + 1.54%/year so far this century, so, once you look past the ultimately bounded squiggles in interest costs and tax rates, that's roughly the amount the true very long term value of the S&P 500 index has probably risen (and will likely continue to rise, give or take). Add around 2%/year in value generation for the dividends.
[That's using the non-financial subset as a proxy for the whole set of firms, which isn't too unreasonable an approximation]

The advice I give to my younger relatives: if things are going well, any index is fine. A rising tide lifts all boats. Why work harder?
But when the good times end and the odds start going very substantially against you, simply never hold any material amount of your money in something you yourself deem to be overvalued. i.e., simply don't hold anything that doesn't have a likely forward return--based on self-consistent assumptions--that is good enough to interest you.

The odds have gone substantially against us. So, either live with very low expectations for returns for a long time, or do something to improve the returns in your portfolio. Either get more selective, or try your hand at the unreasonably difficult game of timing. Personally, I keep a portfolio mainly of equities that aren't priced in a bubbly way, plus at the moment a pretty good pile of cash for opportunistically buying things on price plummets. My picks will certainly drop in the next bear market along with everything else, but, unlike the really bubbly things, their prices will come all the way back again.


I can easily refute the claim that our profits were due to "one-time falls in interest costs".

It's the long term interest cost to companies, not the current headline rate, that matters here.
What can I say? Read the paper from the Fed. I look forward to your refutation of their conclusions, with similarly strong data support.
I'm not saying that facetiously: I would love for their conclusions to be wrong.

Jim

we all did well because we stayed fully invested at all times

What is "at all times"? When did they start for you, so that you made that experience (that you did well be simply staying fully invested)? The last 3 decades or so? If so: Congratulations! But for other people, having made their experiences during other times, staying fully invested was different:

As Morgan Housel expresses it in "The Psychology of Money":
people’s lifetime investment decisions are heavily anchored to the experiences those investors had in their own generation.................
The person who grew up when inflation was high experienced something the person who grew up with stable prices never had to.
The stock broker who lost everything during the Great Depression experienced something the tech worker basking in the glory of the late 1990s can’t imagine.

Maybe your kids will make not your experiences by staying fully invested but the experiences of the other ones?

How solid do we think that the inflation assumptions are when looking at past valuations? I'm having trouble wrapping my head around the money printing that has gone on during the last few decades, particularly in the last 3-5 years. As other countries also print money and/or also have increased funds because of the US monetary policy, how do we know/estimate what a reasonable price estimate is for US stocks if international investment increases?

Addendum: virtually every conversation with equity investors these days revolves around how eye-wateringly expensive American stocks are. Should earnings growth disappoint even a little, large losses loom.

No, it's not from Jeremy Grantham or another "Doomsday prophet".

https://www.economist.com/finance-and-economics/20...

While "eye-wateringly expensive" might not be true for all: What if "earnings growth disappoint" happens for the mighty 7 (as they are valued for perfection)?

Record high? Rates have returned to more normal levels from RECORD lows

The last time the 10-year T-bill was above 5% was in 2006, which was 17 years ago. So, yes, I should say that it's a record high since Shakira sang "Hips Don't Lie" - a looong time ago.

As far as a history lesson, interest rates on the 10-year kept going UP from 2004 through 2006, and yet stocks did fine through that period. Here are the returns.

Year S&P 500  Peak
     Return   10-year rate
2004   9%       4.8% 
2005   3%       4.6% 
2006  14%       5.0%

From the beginning of Jan 2004 through December 2006, interest rates went from 3.8% to 4.8% on the 10-year, and yet the stock market delivered a total return of 28% over that 3-year period.

Here is a historical chart of the 10 year bond yield - gives some perspective on things - and why we aren't anywhere close to record high interest rates.

https://www.macrotrends.net/2016/10-year-treasury-...

At first glance it would appear there is very little correlation between the rates and equity returns. Interest rates dropped significantly from 2000 - 2010 yet stock returns were pretty dismal. The thing to focus on are profitability and valuation (the value of those profits). Interest rates act as a headwind or tailwind for both. When interest rates rise, the cost of capital increases which reduces profitability. In addition when rates rise, the relative value of those profits can be diminished.


You aren't going to see this show up in equity returns immediately, but it will start to drag on things for sure.


tecmo
...

Here is a historical chart of the 10 year bond yield

Yes, that's exactly the chart I referenced when I made the point that the S&P 500 still delivered a total return of 28% during a 3-year period (2004-2006) when interest rate levels were similar to today's 5% level.

If you had listened to a pessimist who wrote an academic paper on why you should avoid the market because interest rates had risen to 5%, you would have given up 28% of compounded gains, to the detriment of your retirement.

At first glance it would appear there is very little correlation between the rates and equity returns.

It's not just at first glance. You'll see it on the chart on your 2nd and 3rd glance as well.

Interest rates dropped significantly from 2000 - 2010 yet stock returns were pretty dismal.

Yep. This again shows the lack of a clear correlation between interest rates and market returns. There may be a vague correlation but it's not consistently actionable.

So keep dollar cost averaging into the market even during downturns like 2000-2010, thereby snapping up shares of quality companies at bargain prices. People who did this became 401K millionaires during the decade that followed, and there are tens of thousands of us. What we most certainly did not do is to listen to pessimists and their gloom and doom forecasts.

Non-financial S&P 500 sales have risen at only inflation + 1.54%/year so far this century, so, once you look past the ultimately bounded squiggles in interest costs and tax rates, that's roughly the amount the true very long term value of the S&P 500 index has probably risen (and will likely continue to rise, give or take). Add around 2%/year in value generation for the dividends.

Many people should pay attention to this above. The long term value gain is the gain in sales (immune to one off adjustments such as tax policy or margin trends linked to economic conditions) plus the dividend yield.

An important corollary is that intrinsic value gains are not, as many tend to think, independent to market price. The sales increase doesn’t relate to market price, but the dividend yield of course does. Historically the yield was around 4%, and with sales growth of 2% leads to the so called Siegel Constant of around 6% real for the total stock market return. Call this the “IV gain base rate”, which contrary to being a constant, is a variable that changes very significantly from one decade to another and is measurable

But most of this IV gain is from the dividend yield, not the sales growth. And with the yield down from 4% to 1.5% you are now getting a long term return of 3.5% instead of 6% *even if valuations remain indefinitely high*.

This underlines why entry price is so important. When entering the S&P500 at a low price (high yield) you not only have a much higher return (even with valuations remaining indefinitely low) but you have the added benefit of the multiple (valuation) increasing, so your return will greatly exceed the 6% “IV gain base rate”.

Now we have both a lower IV gain base rate of 3.5%, but your actual return will likely be markedly lower from the likely fall of the price to sales multiple.

It is sound to keep your expectations lower than usual, and make decisions accordingly.

Note the high correlation of all stocks with the broad market over 1 to 2 year periods - you generally need to look out 4+ years for individual value stock purchaes (whether that be Google or Brookfield Corporation) to become decoupled with the broad market.

Having cash aside, to enter into the market when the IV gain base rate is higher, is tricky because often 1
the valuations keep rising for too long, you become impatient and enter anyway at and even higher price; or 2 when the valuations are lower, the observation of the price falls makes you feel as they will fall further, so you wait perpetually and eventually it recovers and you miss the opportunity. But waiting with cash to pricier lower be done by some. The CAPE now is at a high valuation observed only around 2% of the time the last 170 years, so valuations can go higher but thr mean reversion is definitely down and not up.

I personally remain fully invested and select a concentrated portfolio that have the intrinsic value ten years away mich higher than the quotation today - and then attempt to apply the necessary, almost required as ludicrous, amount of patience, given the strong correlation between just about all stocks and the broad market over 1 - 4 year periods.

- Manlobbi

I have posted this quote from Warren Buffett often on the BRK board. It is from his 1999 Sun Valley address, which was dismissed by some, but proved prophetic in a few years. He points out a worst case scenario, from 1964 through 1981, when the DOW, while paying dividends, had no appreciation over a 17 year span. We have had a long period of over-sized appreciation in stock prices, and that will have to at least level out at some time.

"You cannot expect to forever realize a 12% annual increase...in the valuation of American business if its profitability is growing only at 5%. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.

Now, maybe you'd like to argue a different case. Fair enough. But give me your assumptions. If you think the American public is going to make 12% a year in stocks, I think you have to say, for example, "Well, that's because I expect GDP to grow at 10% a year, dividends to add two percentage points to returns, and interest rates to stay at a constant level." Or you've got to rearrange these key variables in some other manner. The Tinker Bell approach--clap if you believe--just won't cut it."

What can I say? Read the paper from the Fed. I look forward to your refutation of their conclusions,

I read the paper. It was an insult to the intelligence, and a complete waste of time. "The end of an era" is scare-mongering nonsense. It's the same scare-mongering we've heard from talking heads over the years which turned out to be utterly false.

What Smolyansky is saying is that the entire 30-year period from 1990 to 2020 was a lucky fluke for stock market investors because of low interest rates and low corporate tax rates. According to him, that era has just ended, interest rates and tax rates will rise, and your luck has just run out. Go sulk. Future market returns will be bleak and miserable.

The above conclusions are ridiculous on their face, and easy to refute. First of all, if low taxes and interest rates were the catalyst for stocks to go higher during this "lucky" 30-year period, why did the market go down 49% during 2000-2002 and down 57% during 2008-2009? Did you feel lucky during these periods?

So Smolyansky's assertion that the 1990-2020 period was a "lucky" one due to low interest rates and taxes can be refuted by the "lost decade" of 2000-2009.

But it can also be refuted by the great bull market of 1975-1985, an 11-year period which delivered a CAGR of almost 15%. During the latter part of the 1970s, the top corporate tax rate was as high as 70%! I kid you not. In the early 80s, the tax rates came down to 46%, still high. To add insult to injury, interest rates went straight up from 7.5% in 1975 to a peak of 15% in 1981. It wasn't until Reagan's Tax Reform Act of 1986 that corporate taxes were lowered to 28%.

According to Smolyansky, the double whammy of 70% corporate tax rates and 10+% interest rates should have delivered a knockout punch to the stock market. But that didn't happen. Investors during that 1975-1985 period enjoyed annualized returns of 15%, which is 5% above the long term average.

So there you go. I've made 2 points, with data, to refute the contents of the paper. The guy who wrote the paper is an economist at the Fed. Economists at the Fed can't even predict that inflation is not "transitory", what makes you think they can predict the stock market?

What you should do instead
If you are in your wealth building years, and have a job with a 401K, set aside 6 months of emergency living expenses, and any large expenses (like college or a new car) that you expect to incur in less than 3 years in cash. Then set up automatic transfers of 10% of your paycheck into an index fund in your 401K plan. Don't get cute and try to time the market, and for God's sake don't listen to fear mongerers.

For me, the scariest time was during the banking crisis of 2008, with banks like Lehman, WaMu and Countrywide failing all over the place. But I still kept dollar cost averaging into my 401K and focused on my career rather than the market. This is called time diversification. I look back on those contributions now and marvel at cheap I bought the shares at.

To succeed in the market and achieve your retirement goals, you don't need to be a finance whiz or a math genius. You just need to keep your head while others are losing theirs.

Cheers,
Mechinv

Paper referenced: https://www.federalreserve.gov/econres/michael-smo...

"I read the paper. It was an insult to the intelligence, and a complete waste of time. "The end of an era" is scare-mongering nonsense. It's the same scare-mongering we've heard from talking heads over the years which turned out to be utterly false."

It is quite telling that you need to resort to such phrases as "insult to intelligence", "nonsense", and "scare-mongering" rather than just try and understand what is actually being said. It is clear you are completely missing the point of the paper cited.

Why don't any of your hand waving dismissals address the valuation aspects the author of the original post made?

"The above conclusions are ridiculous on their face, and easy to refute. First of all, if low taxes and interest rates were the catalyst for stocks to go higher during this "lucky" 30-year period, why did the market go down 49% during 2000-2002 and down 57% during 2008-2009? Did you feel lucky during these periods?"

Grear example of missing the forest through all of the trees.

What do you think market valuations were before those drops? Why do you think valuations recovered so quickly both of those times you mentioned (and yes, historically, two and a half years is fast for a recovery).

"But it can also be refuted by the great bull market of 1975-1985, an 11-year period which delivered a CAGR of almost 15%. During the latter part of the 1970s, the top corporate tax rate was as high as 70%! I kid you not. In the early 80s, the tax rates came down to 46%, still high. To add insult to injury, interest rates went straight up from 7.5% in 1975 to a peak of 15% in 1981. It wasn't until Reagan's Tax Reform Act of 1986 that corporate taxes were lowered to 28%.

According to Smolyansky, the double whammy of 70% corporate tax rates and 10+% interest rates should have delivered a knockout punch to the stock market. But that didn't happen. Investors during that 1975-1985 period enjoyed annualized returns of 15%, which is 5% above the long term average."

Again, you don't mention valuations. What was the stock market valuation in 1975 and then in 1985? Also, rates dropped fairly significantly between 1981 and 1985 (the end point of your cherry-picked example) which sort of supports the OP's point (but the time frame is really too small either way).

"I've made 2 points, with data, to refute the contents of the paper. The guy who wrote the paper is an economist at the Fed. Economists at the Fed can't even predict that inflation is not "transitory", what makes you think they can predict the stock market?"

What makes you think they were predicting the stock market? They were discussing the causes of the ridiculously high valuations of the market and the factors that caused it.

"If you are in your wealth building years, and have a job with a 401K, set aside 6 months of emergency living expenses, and any large expenses (like college or a new car) that you expect to incur in less than 3 years in cash. Then set up automatic transfers of 10% of your paycheck into an index fund in your 401K plan. Don't get cute and try to time the market, and for God's sake don't listen to fear mongerers.

For me, the scariest time was during the banking crisis of 2008, with banks like Lehman, WaMu and Countrywide failing all over the place. But I still kept dollar cost averaging into my 401K and focused on my career rather than the market. This is called time diversification. I look back on those contributions now and marvel at cheap I bought the shares at."

The OP factually points out that over the last 30 years stock markets have reached ridiculously high valuations by almost any measurement (P/E, price to sales, etc.) and you then suggest that someone should do just as you did by just investing regularly during the time period of increasing valuations? That completely misses the point. That is the most "Duh!" statement ever.

I don't think any person with an IQ over 80 would argue against the fact a person could do well by regularly investing in a market that is going to have ever increasing valuations. If you told any mildly intelligent, rational person that the stock market was going to be at higher valuations (as measured by P/E or P/S) 30 years from now, then of course they would agree that investing regularly over the next 30 years would be a smart move. The problem with your suggestion is that it requires valuations to keep increasing and be higher in 30 years.

If you think the paper is garbage, then what are your explanations for the fact that valuations have increased ridiculously in the past 30 years? If you don't think it is because of taxes and interest rates then what are your explanations?

In response to the previous post on this thread, let me quote directly from the Abstract of the "End of an Era" paper. You can read it at https://www.federalreserve.gov/econres/feds/files/...

Smolyansky says:
"the boost to profits and valuations from ever-declining interest and corporate tax rates is unlikely to continue, indicating significantly lower
profit growth and stock returns in the future. "

He defined 1989-2019 as a "golden era" of excessive stock market returns. Well, it's obvious that the ever-declining interest rates part is wrong, isn't it? During 1993-94, interest rates on the 10-year T-bill rose from 5.4% to almost 8%, yet the market did pretty well. These rates are far higher than we have today. Rates also rose during 1998-99.

He also says these "ever-declining" interest rates are unlikely to continue. Wrong again. The Fed just forecast not one but three rate cuts next year. So interest rates will decline next year.

His other assertion, that the Federal corporate tax rate of 21% is unlikely to remain that low, remains to be seen. In some states, like CA and NY, combined Federal and State income taxes can hit 28%.

The problem when writing about investing to a general message board is that one size does not fit all. You have to find a strategy that's right for you. Some of you may be retired or financially independent baby boomers like me. Others of you may be millenials, GenX'ers or GenZ-ers in your wealth building years. What I said was that, primarily for this latter group, who are decades away from retirement, a DCA strategy into an index fund worked for me in my younger years, despite two long-drawn-out and severe recessions.

I think a bit of the disconnect here is the timeframes that each of us is contemplating.

Example:
He also says these "ever-declining" interest rates are unlikely to continue. Wrong again. The Fed just forecast not one but three rate cuts next year. So interest rates will decline next year.

Again, looking at the LONG TERM trend in interest rates - they were MUCH MUCH higher 20 years ago, and essentially zero very recently. This LONG term decline in interest rates is probably over (unless you think rates can go negative - which they kind of did). Are rates SLIGHTLY higher now? yes, will they be SLIGHTLY lower by the end of next year? Probably. But in general there is no opportunity for the kind of declines that we saw in the last 40 years.

The market can do almost anything in the short term - (which I define as 3 years or less) - but the basic formulas still hold

Equity Price = (Financial Metric) x (Financial Multiple)

1. Financial Metrics (Sales, Profits) are hard to grow faster than the economy is growing.
2. Financial Multiples seem high and a BIG tail wind (declining rates and tax rates) seems to be turning into a neutral benefit at best(*).

Thus Equity Prices seem at best to be constrained going forward.


(*) Tax rates absolutely could be cut even more, in fact they could go to zero I suppose - but I wouldn't bet on it.

tecmo
...

The conclusions in the "End of Era" paper are easy to refute. When you make a sweeping statement like "low corporate tax rates are what led to excess stock market returns", then a single counter-example disproves the thesis.

Let's look at the 10-year period before corporate taxes were slashed to 34% by the Tax Reform Act of 1986. During this period, where corporate taxes were as high as 48%, investors enjoyed a CAGR of 17.6%

Annual S&P 500 returns during high-tax period.
1976: 23.84%
1977: -7.18%
1978: 6.56%
1979: 18.44%
1980: 32.42%
1981: -4.91%
1982: 21.55%
1983: 22.56%
1984: 6.27%
1985: 31.73%
------------
CAGR: 17.6%

Now, let's look at S&P 500 returns during the 10-year period after Reagan's Tax Reform Act of 1986 slashed the top rate from 48% to 34%.

Annual S&P 500 returns during low-tax period.
1986	18.67
1987	5.25
1988	16.61
1989	31.69
1990	-3.10
1991	30.47
1992	7.62
1993	10.08
1994	1.32
1995	37.58
------------
CAGR: 12.4%

The fact that investors during the lower taxes period experienced a far lower return (12.4%) than those in the high tax period disproves Smolyansky's thesis. Note also that the lower taxes period featured the October 1987 market crash (worst single-day crash in market history) and the 1990 bear market.

The relationship between corporate tax rates and stock market returns is complex and often debated, with no clear-cut answer. While a simple assumption might be that higher taxes would directly harm companies and decrease stock prices, the reality is far more nuanced. For example, increased tax revenue could be used by the government to stimulate the economy through infrastructure projects or social programs. This could potentially benefit certain sectors and overall economic growth, indirectly impacting stock market performance.

The other often-neglected factor in stock market returns is investor sentiment. We've all seen periods where there is bad news on earnings, yet the market "shrugs it off", and other periods where even great news on earnings is not enough for vicious sell-offs. This is why its so hard to show correlations between stock market returns and macro-economic factors. The stock market is not the economy.

The best thing to do, if you are a GenX-er, Millenial, or GenZ-er in your wealth-building years, and lucky enough to have a job with a 401K plan, and 10 or more years to go before retirement or a big expense like funding college, is to live frugally, save 10% of your paycheck automatically into an index fund every month, and focus on your career rather than the stock market. It's the best way to achieve your retirement goals.

The thread has diverged a bit. Mechinv - two questions for you.

Profits have risen faster than sales recently. Do you think this trend will continue? If so, what will be the primary driver? If not what are the implications for equity valuations?

tecmo
...

tecmo asks
Profits have risen faster than sales recently. Do you think this trend will continue? If so, what will be the primary driver? If not what are the implications for equity valuations?

These are all great questions. Your observation that profits have risen faster than sales is spot on. Let's review the earnings forecasts and growth drivers of the 4 largest US corporations.

Microsoft
Microsoft's year-over-year sales and earnings growth during the last quarter (fiscal Q1 2024, which ended September 30, 2023) were:

Sales:

12.76% increase: Revenue for the quarter ending September 30, 2023 was $56.517 billion, a 12.76% increase from the same quarter in 2022.

24% growth in Microsoft Cloud: This segment, which includes Azure, Office 365, and other cloud services, saw even stronger growth at 24% year-over-year (23% in constant currency).
Earnings:

38% increase in non-GAAP diluted EPS: Microsoft's non-GAAP diluted earnings per share (EPS) were $2.35, a 38% increase from $1.70 in the same quarter of the previous year.

Microsoft also provided a forecast for its fiscal second quarter of 2024 (ending December 31, 2023):

Revenue:

$60.4 billion to $61.4 billion: This represents a range of 15% to 16% growth year-over-year.

So Microsoft said its YoY sales growth will accelerate from 12.8% last Q to 15% this Q. Analysts see the primary drivers of this growth being 1) continued momentum in Azure and 2) Microsoft 365 Copilot, an AI-powered assistant within Office 365, which is seen as a game-changer for productivity software. Analysts believe its potential to boost user efficiency and create new revenue streams is substantial.

As far as valuation, Peter Lynch used the PEG ratio for growth stocks. MSFT has a forward P/E of 33, and it's EPS growth is 38%, giving it a PEG ratio = 33/38 which is below 1.0. The stock would be considered undervalued according to this ratio.

Apple
From the latest earnings call...
Sales:

Slight decline of 1%: Their total revenue reached $89.5 billion, falling just short of the previous year's figure.
Notable variations by product: While iPhone sales grew modestly by 2%, the wearables category and Greater China sales (including Hong Kong and Taiwan) experienced declines.

Earnings:

Positive growth of 13%: Net income reached $22.96 billion, exceeding the previous year's $20.72 billion. This translates to $1.46 earnings per diluted share, compared to $1.29 in the previous year.

Apple, unlike Microsoft, doesn't traditionally provide specific guidance for future sales and earnings during its earnings calls.
Overall tone:

Tim Cook, CEO of Apple, expressed positive sentiment about the company's future, highlighting strong momentum in several key areas like wearables and services.
He emphasized their commitment to innovation and their confidence in their product pipeline.
Growth areas:

Cook specifically mentioned wearables as a category with "very strong double-digit year-over-year growth" and significant potential for further expansion.
Services segment, including App Store, Apple Music, and iCloud, was also highlighted as a major driver of future growth.
Continued focus on emerging markets like India and Southeast Asia was mentioned as another potential avenue for expansion.

While exact numbers for future sales and earnings weren't provided, the overall tone and specific areas of focus suggest confidence in continued growth, particularly in wearables and services.
Analysts generally project moderate revenue growth for Apple in the coming quarters, ranging from 2-5%.
However, uncertainties remain regarding factors like global economic conditions and potential product delays due to supply chain issues.

It's difficult to value a company that does not provide sales or earnings forecasts. On the surface, its PEG ratio of 2.3 makes this stock look expensive. If you are a Warren Buffett fan, though, note that in the latest 13F filing by Berkshire Hathaway, shares in Apple have remained constant (none sold) in the latest quarter. Berkshire holds 915 millions shares of AAPL, which is 48% of its entire equity holdings. This is a tremendous amount of conviction in the company.

Alphabet (Google)
From the latest earnings call...
Sales:
Increased by 11% year-over-year, with revenue reaching $76.693 billion. This marks the first time in four quarters that Alphabet's revenue growth was in double digits.

Earnings:
Net income grew by 46% year-over-year, reaching $19.7 billion. This translates to $1.55 earnings per diluted share, beating analyst expectations.

EPS and revenue are forecast to grow by 14.9% and 10% year over year, respectively. This gives the stock a forward P/E of 21 and a PEG ratio of 1.3.

Several key factors are seen as potential drivers for Google's revenue and earnings growth in future quarters:

Advertising resurgence:

Rebound in ad spending: After a slight dip in ad spending during 2022 due to economic uncertainties, analysts expect a resurgence in advertising budgets, benefiting Google's core revenue stream.

AI-powered ad solutions: Google's continued development of AI-powered ad targeting and optimization tools could attract more advertisers and improve click-through rates, boosting revenue.

YouTube monetization: Google's focus on monetizing YouTube through ads and subscription models like YouTube Premium could further unlock its growth potential.

Cloud computing momentum:

Google Cloud's strong performance: Google Cloud has been experiencing impressive growth, closing the gap on its larger competitors like Amazon Web Services (AWS) and Microsoft Azure. This trend is expected to continue, driving revenue and profitability.

AI advancements: Google's leadership in artificial intelligence (AI) research and development could translate into successful commercial applications like voice assistants, chatbots, and personalized search experiences, generating new revenue streams.

Amazon
From the latest earnings call...
Sales:
Increased by 13% year-over-year, reaching $143.1 billion. This was a record quarter for Amazon in terms of sales.

Key drivers: Growth was fueled by strong performance in all three segments:
North America: Sales grew 11% year-over-year to $87.9 billion.
International: Sales grew 16% year-over-year to $32.1 billion.
Amazon Web Services (AWS): Sales grew 12% year-over-year to $23.1 billion.

Earnings:
Non-GAAP EPS: Increased by 20% year-over-year to $0.94 per share. This reflects a significant improvement over the previous year's non-GAAP EPS of $0.79.

Amazon has a forward P/E of 39, so it's PEG ratio is around 2.0.

Advertising has been the fastest-growing business segment for Amazon over the past few quarters, Other revenue drivers include:
Increased customer demand
AWS revenue recovery, including new services related to AI/ML
Expansion into new markets
Diverse product offering
Increasing leverage for retail business
Cost discipline for big bets outside core businesses

I hope this helps. The next 3 largest companies are Nvidia, Mets and Tesla. I leave it to the reader to do a similar analysis as above.

38% increase in non-GAAP diluted EPS: Microsoft's non-GAAP diluted earnings per share (EPS) were $2.35, a 38% increase from $1.70 in the same quarter of the previous year.

Its not clear what quarter you are referring to, the most recent quarter for MSFT was $2.99 EPS up from $2.35 a year ago. The last time MSFT earned $2.35 per share was that quarter and it was up $2.27 per share. The numbers you posted don't make a lot of sense and thus the entire valuation argument is a bit suspect (I also doubt using YoY PEG numbers would provide really any insight either).

https://www.cnbc.com/2023/10/24/microsoft-msft-q1-...



But this is a digression, my point was sort of made with the response (which I actually appreciate - even if it is off track). I am thinking more LONG term and in AGGREGATE profits vs. sales. (ie: not next year, but say the next 5 - 10 years). It would seem you are very much focused on the short term.


For the S&P-500 in its entirety, the question remains.
Profits have risen faster than sales recently. Do you think this trend will continue? If so, what will be the primary driver? If not what are the implications for equity valuations?

I guess one answer that I might infer from your response is that profits will continue to concentrate in the largest companies; and that their already profit margins will expand? If you believe this, my question would be how long do you think this trend will continue?

tecmo
...

Its not clear what quarter you are referring to, the most recent quarter for MSFT was $2.99 EPS up from $2.35 a year ago.

Yes, I realized after I wrote the post that the $2.35 figure was the prior year quarter. For the most recent quarter, the $2.99 EPS represents 27% YoY EPS growth. Assuming Microsoft can achieve an EPS of $3.81 (27%) growth in the quarter ending Sep 30, 2024, it's forward P/E ratio would be about 25. At 27% EPS growth, that gives it a PEG ratio below 1.

One driver for achieving EPS closer to $14 or $15 per share next year would be the upgrade to Office 365 Copilot, which brings an AI assistant to automate tasks for office workers.

Profits have risen faster than sales recently. Do you think this trend will continue? If so, what will be the primary driver?

I analyzed earnings forecasts of the largest companies to try to find trends. The obvious trend I find in companies such as Microsoft, Nvidia, Amazon and Google are massive new revenue streams resulting from AI, and particularly Generative AI.

ChatGPT was the fastest-growing consumer internet app of all time after its launch, notching an estimated 100 million monthly users in just two months. Facebook, for example, took around four and a half years to hit 100 million users after launch.

Microsoft invested $10B in Open AI. That company is now valued at more than $80B, and it's still private.

The use of gen AI in finance is expected to increase global gross domestic product (GDP) by 7% —nearly $7 trillion—and boost productivity growth by 1.5%, according to Goldman Sachs Research.

https://www.investopedia.com/economic-impact-of-ge...

If I go by analyst projections, MSFT's consensus projected EPS for the fiscal year ending June 2025 is $12.7. For June 2026, it is $15.

So if we assume MSFT grows in line with analyst's projections, it's at 25 p/e for July 2025 - June 2026 earnings (i.e., the fiscal year starting 18 months from now). For 2025 - 2026 (still further afield than "forward P/E"), it is at 29.45 P/E.

Maybe the analysts are significantly underestimating how fast MSFT (and its 2.78 trillion dollar market cap) can grow, but those aren't exactly bearish EPS growth projections.

Here's one analyst's estimate of the incremental revenue Microsoft could see from its Office 365 Copilot, which is an AI-powered assistant that can summarize documents, generate presentations from outlines, create action items from meeting notes, etc.

"Macquarie forecasts that Microsoft by the end of FY’25 (June) could generate approximately $7.3 billion of incremental annual recurring revenue (ARR) from 365 Copilot based on estimated initial uptake of 5% (about 20 million users). By FY’26, the Copilot portfolio of products can generate $9.1 billion in revenue and 49 cents in per-share earnings, according to the firm. Macquarie thinks Microsoft shares are undervalued based on the Copilot profit potential. The firm recently lifted its Microsoft price target to $430 from $405."

https://www.forbes.com/sites/robertdefrancesco/202...

https://blogs.microsoft.com/blog/2023/03/16/introd...

One driver for achieving EPS closer to $14 or $15 per share next year would be the upgrade to Office 365 Copilot, which brings an AI assistant to automate tasks for office workers.

It would be shocked if MSFT were to get anywhere close to $14 EPS next year let alone $15, even $13 EPS would be a tremendous performance. The last four quarters where $2.99 + $2.69 + $2.45 + $2.32 = $10.42. Getting to $14.00 would mean EPS growth of 35% next year.

Getting to north of $12.00 EPS would be IMO a solid year for them - and unsurprisingly from this I have a stock price target that is pretty flat from current levels. The biggest variable is unlikely to be their business performance but rather market sentiment - which is notoriously hard to predict. The highest EPS multiple they have traded at (in the past 7 years) was 37x which would put the BULL case at $445 (+20% from current levels); with the more conservative at 28x which would suggest a target of $336 (-10%).

tecmo
...

PS: I am a long term MSFT shareholder and don't plan on selling nor adding at current levels. It would consider adding if prices got below / near $300 again.

Getting to north of $12.00 EPS would be IMO a solid year for them

They're already at ~$3.00 EPS for the last quarter. Multiply that by 4. Achieving only $12 annual EPS implies zero percent QoQ EPS growth over the next 4 quarters. That's way too pessimistic, IMO.

Here's Microsoft's actual QoQ EPS growth over the last 3 quarters.

       EPS   QoQ EPS Growth
Q3-23  2.99  11.6%  
Q2-23  2.68   9.4%
Q1-23  2.45  11.3%

So MSFT averaged 10% QoQ growth over the last 3 quarters.

More to the point, you had asked what the drivers would be for continuing this level of QoQ growth. I had replied that analysts at MacQuarie estimate that Microsoft will earn north of $10 billion of additional revenue over the next 2 years due to Office 365 Copilot, the GenAI powered task assistant. Does this help answer your question? None of the 10% EPS growth over the last 3 quarters includes any revenue from Copilot.

PS: I am a long term MSFT shareholder and don't plan on selling nor adding at current levels.

Congratulations, and I sincerely hope you have a prosperous year ahead.

I never used Clippy or Cortana, and will probably not use Copilot.

Microsoft Paperclip (1997 to 2003)
Cortana (2015 to 2023)
Microsoft Copilot (2023 to ???)

I don't see anything replacing the Google/Microsoft/Apple operating systems. Security has become too important for new players to compete. AI is making computers even more useful, and so will expand the market for these companies. (Possibly, one of them makes an Intel-sized mistake and the market shifts. No sign of that today.)

Operating System Market Share Worldwide - November 2023
Android 38.27%
Windows 30.6%
iOS 16.54%
OS X 9.4%
Chrome OS 1.66%
Linux 1.44%
https://gs.statcounter.com/os-market-share

Copilot is not a new operating system. It's an upgrade to Office 365 that just got released in November.

40% of the Fortune 100 have already been using a beta version since May. “Customers tell us that once they use Copilot, they can’t imagine work without it,” Microsoft CEO Satya Nadella told analysts on a conference call last week.

"The feature that appears in Word, Excel and other Office programs will cost $30 per person per month. That can add up to more than $10 billion in annualized revenue by 2026, Piper Sandler analysts Brent Bracelin and Hannah Rudoff wrote in a note to clients earlier this week."

Ref: CNBC - https://www.cnbc.com/2023/11/01/microsoft-365-copi...

What can Copilot do? Here's just a sampling. There's also a demo you can watch at https://www.youtube.com/watch?v=ebls5x-gb0s

Content Creation and Editing:

Jumpstart creating documents and presentations: Provide a brief prompt or topic, and Copilot will generate a first draft or outline for you to work on.

Suggest content based on context: Need to add data charts or images? Copilot can analyze your document and recommend relevant visuals to enhance it.

Offer writing suggestions: Improve your writing with Copilot's grammar and clarity checks, synonyms, and sentence rephrasing options.

Summarize text and audio: Get a quick grasp of lengthy documents or meetings by having Copilot condense them into concise summaries.

Data Analysis and Insights:

Uncover trends in spreadsheets: Easily find patterns and outliers in your Excel data with Copilot's analysis tools.

Generate insights from emails and conversations: Analyze email threads and meeting transcripts to identify key points and action items.

Create data visualizations: Transform your Excel data into stunning charts and graphs with Copilot's assistance.

Collaboration and Task Management:

Automate repetitive tasks: Delegate routine tasks like formatting emails or scheduling meetings to Copilot to free up your time.

Translate languages on the fly: Communicate effortlessly with international colleagues by using Copilot's real-time translation feature.

Manage your schedule and to-do list: Let Copilot help you organize your calendar, set reminders, and prioritize tasks.

They're already at ~$3.00 EPS for the last quarter. Multiply that by 4. Achieving only $12 annual EPS implies zero percent QoQ EPS growth over the next 4 quarters. That's way too pessimistic, IMO.

Well, the earnings are in, with a "beat". $2.93 / share - well short of $3.00 which was "way too pessimistic". Next quarter consensus estimate is $2.64, I think they can do better, but getting to $3.00 will be difficult.

tecmo
...

Well, the earnings are in, with a "beat". $2.93 / share - well short of $3.00 which was "way too pessimistic".

What I actually said is that zero percent QoQ growth over the next 4 quarters is way too pessimistic. The $2.93 EPS for the latest quarter is excellent - it's 33% higher than the EPS reported in the prior year quarter.

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