“Time present and time past
are both perhaps present in time future,
and time future contained in time past.”
-T.S. Eliot, Burnt Norton, 1
Extraordinary Times
The experience of watching the broad stock indices march higher for months threatens to mislead us into thinking we have embarked upon a new era of investing. Since March of 2009, the S&P 500 Total Return Index (including reinvested dividends) has increased more than 300%; in other words, $10,000 invested then would have been worth over $40,000 at the turn of the new year. Research in the field of Behavioral Finance suggests that we are inclined to extrapolate this extraordinary recent trend well into the future.
The thing is, stock prices have increased faster than corporate earnings (think “profits”) during this period – much faster. This is worrisome because earnings growth is a key factor behind long-term stock price growth. Using annual data from S&P Dow Jones Indices, earnings per share for the S&P 500 increased 120% from 2009 to 2017. This difference in stock price and earnings growth (300% vs. 120%, respectively) calls for focus on another factor essential to understanding long-term stock price trends. The Price-Earnings (PE) ratio for the S&P 500 Index now stands over 26, well above the long-term historical average of less than 16 (per this source).
In other words, investors now pay $26 dollars for a dollar of corporate earnings, $10 dollars more than the average amount investors have been willing to pay long-term. To simplify, think of the PE ratio as a measure of stock price inflation. The underlying value of corporations whose shares are included in the stock market indices is increasing as earnings grow, but stock prices are increasing at a rate beyond that rate of earnings growth because investors are willing to pay more for each dollar of those growing earnings. Optimism about the economy could be a reason for this extra willingness to pay, as investors in aggregate accept greater risk of loss.
PE ratio figures are tricky to interpret for numerous reasons, such as differences in calculation methodology, the lag in reporting of earnings data, inflation and fluctuations in earnings due to the business cycle. Indeed, the above-linked PE graph for the years 2008-10 has the contours of an electrocardiogram plot (with a sharp spike in the data), due to the impact of the financial crisis on stock prices and earnings. The important observation here is that investors are willing to pay over 60% more for each dollar of corporate earnings relative to the historical average investors have been willing to pay per dollar of earnings.
Through the Long-Term Looking Glass
Economics Nobel laureate Robert Shiller adjusts the S&P 500 PE ratio for inflation by adjusting earnings and stock prices using the Consumer Price Index (CPI) going back to the late nineteenth century. Shiller then averages the ratio of stock prices to earnings over ten years to smooth over swings in the business cycle. His Cyclically Adjusted Price Earnings ratio (CAPE) increased from 13 to almost 34 from March 2009 to mid-January 2018, an increase of more than 150%. In theory, had earnings kept pace with stock prices, the CAPE would have remained steady over this period. Instead, as of this writing the CAPE is more than twice its historical average of just under 17. In other words, after adjusting for inflation and for swings in the business cycle, investors today are willing to pay more than twice as much for a dollar of earnings as they have been willing to pay on average over the historical period since the 1880s. In fact, this measure now hovers around levels higher than those seen prior to historic events such as Black Monday (1987), or Black Tuesday (1929), and lower only than those seen during the technology (“Dot Com”) stock bubble of the late 1990s and its aftermath in the early 2000s.
The Tax Cut Accelerant
Granted, the Tax Cuts and Jobs Act of 2017 raised earnings growth expectations for 2018 and beyond by reducing corporate tax rates. However, it is hard to imagine that earnings growth will somehow “catch-up” with the quadrupling of stock prices we have seen over the past nine years. There are limits to what can be done to boost earnings from tax changes, especially those tax decreases that are financed by debt.
Bipartisan sources estimate that the national debt will increase $1 to $2 trillion as a result of the individual and corporate tax rate reductions in this law. An increase in the supply of U.S. Government bonds to finance this extra debt will, all else remaining equal, raise interest rates and dampen anticipated earnings growth by raising the cost of living and increasing the cost of doing business, thus serving as a limit on anticipated increases in consumer spending and business investment.
A Return to Normal Looms
One never knows what will happen next in financial markets. We could see a “correction” in stock prices (e.g., a fall of 10% or more in the broad stock indices). Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan warns that such an event approaches in a recent WSJ piece, “Stocks Are Headed for a Fall.” Feldstein argues that asset prices, inflated by historic low interest rates and bond-buying by the Federal Reserve meant to spur economic recovery in the wake of the financial crisis, will revert to “normal” levels (i.e., consistent with long-term trends) as these accommodative Fed policies wind down. Should the economy continue to mend and inflation expectations continue to rise, the Fed likely will increase the benchmark Fed funds rate several times this year.
Rather than an abrupt drop in stock prices, we could see a deceleration in growth that compresses returns in the coming years. Keep in mind that a drop does not need to happen in the proverbial blink of an eye, like the plunge of more than 20% in the stock indices on Black Monday in 1987. Prices could fall over a period of years as they did following Black Tuesday in 1929, not bottoming out until mid-1932.
Control the Controllable
Given the uncertainty implicit in the art and science of investing, the best we can do is focus on those things we can control: asset allocation, diversification, costs, and tax efficiency. Focusing on the long-term, provided we have time to play the long game, is best. Whether or not we have the luxury of time, now is a good time to assess whether the amount of risk lurking in our portfolio is aligned with our ability to handle the inevitable ups and downs of the stock market. This self-knowledge will be critical to our ability to withstand the transition to time future, be it extraordinary, normal or somewhere in between.