Total Return
Stock price movements are driven by two variables: earnings growth and changes in the price-to-earnings ratio. Add dividends, and you have total stock returns. The dividend yield of an average stock today is 2% – it is all yours to keep, so my discussion here will focus on the direction of “E” and “P/E.”
If you were to normalize profits for high margins and look at 10-year trailing earnings, in 2008 stocks were trading 66% above their historical average. They were at 30 times 10-year trailing earnings (see next chart).
In all honesty, I could make the same presentation today as I did five years ago (in fact I borrowed and updated a few slides from that presentation – see next chart). Market valuation is not dramatically different now from what it was then. A cyclical bear and a cyclical bull market later, the S&P 500 is still at the same 18 times trailing earnings and 26 times 10-year trailing P/E, or 41% above average. (It was 60% above average in 2008.)
(See footnote at end for a detailed explanation of the above chart.)
Investors who were on the sidelines over the last few years and who are now pouring money into stocks, expecting that we are in the midst of a secular bull market, will likely be disappointed.
The previous sideways market of 1966-1982 had four cyclical bull markets and five cyclical bear markets packed inside it. From 1970 to 1973 the Dow went from 700 to 1,000, just to drop again, this time to 600. Four times, investors thought that a cyclical bull market had turned into a secular (long-term, 1982-1999 type of ) bull market, but their hopes were dashed as they discovered that these were just head fakes toward the next cyclical bear market (see next chart).
It is when nobody wants to own stocks ever again, when valuations are below their historical average, that a secular sideways market finally dies (actually more like goes into hibernation) and the next secular bull market is born.
But even that is not enough: stocks need to spend some time at below-average valuations. In the 1966-1982 secular sideways market, stocks spent half their time at below-average valuations. During the recent crisis we tiptoed into below-average valuations, but we danced right back out. Sideways markets are there to destroy hope and tarnish memories of the last secular bull market.
If you believe we are in the midst of a secular bull market, you have to be very comfortable with three things:
First, profit margins. Today, corporate profit margins are hitting all-time highs.
Historically, profit margins have been very mean-reverting – high margins were never sustained by corporations over a prolonged period of time because, as Jeremy Grantham puts it, “capitalism works.” When a company, Apple Inc. (NASDAQ:AAPL) for example, starts earning very high margins, its competitors (like Samsung Electronics Co., Ltd. (LON:BC94) (KRX:005930)) come in and try to undercut it with lower prices. In response, Apple Inc. (NASDAQ:AAPL) must lower its margins or dispense with a lot more features in its products.
If margins decline even as the economy grows, earnings growth will be very benign or negative. Suddenly, stocks that were seemingly cheap will not be cheap any longer.
Since we’re on the subject, let me dispel the myth that earnings can grow at a faster rate than the economy for prolonged period of time – they cannot and they have not. For this to happen profit margins would have to continuously expand, and as we have discussed above, they don’t.
But don’t just take my word for it. In the chart below I’ve plotted corporate earnings (yellow line) against GDP (red line) from 1957 to 2011. There were periods of time when earnings grew at a faster rate than GDP (profit margins expanded), and then they werealways followed by periods of time when earnings lagged GDP (profit margins contracted). But in the long run earnings growth equaled GDP growth. (This is a large and very important topic: I suggest you read this article.)
To be fair to the “earnings bulls,” earnings per share can outpace both earnings growth and GDP in the long run through share buybacks. When corporations repurchase their own shares the earnings pie is divided among fewer investors, and thus earnings per share will rise at a faster rate than net income. Share buybacks helped the S&P 500 to accelerated earnings per share growth by about 3% a year over the last two years.
Management can create enormous value for shareholders through smart capital allocation (share repurchases and issuance – and, at the right time, dividends and acquisitions). Henry Singleton at Teledyne created one of the most successful companies in the second half of the last century by being a very smart capital allocator.
Unfortunately, in general, corporations have not been good capital allocators; they’ve been buying their stock back high rather than buying (or issuing) it low. In the third quarter of 2007, S&P 500 companies spent $172 billion on buying their own stock – and of course that marked the highest point for the stock market. Fast-forward a few years, and in the first quarter of 2009, when market capitalization of the index declined almost by half, their own stocks should have been unbelievable bargains for companies, right? Yet stock purchases by S&P 500 companies dwindled by 80% from their highs to only $31 billion. (See S&P report and chart below.)
Unlike dividends, which when reduced or cancelled may end up costing management their jobs and are thus very sticky, corporate buybacks are announced and often not followed through on, or are followed through at the wrong time. Don’t count on buybacks to be a significant accelerator of earnings per share growth in the long run.
Second, the global economy. Even if you are comfortable with high profit margins, you have to make an assumption that economic (revenue) growth will be robust going forward; and given how many headwinds we are facing from every corner of the globe, that is far from a given:
Europe. Massive QE has temporarily papered over the Eurozone’s problems, but the structural issues that gave rise to the current crisis have not been resolved.
China is in the midst of residential and commercial real estate and infrastructure bubble that is further
