Since 1900, listed US companies have grown their earnings at just over 1% above inflation. Whereas, over the past 15 years – which includes the trauma of the global financial crisis – the median real earnings of companies in the S&P 500 grew by 6% a year. What are the likely causes of this huge outperformance, and can it last?
Recently, I looked at the important issue of stock buybacks. All stock investors must take buybacks into account when making investment decisions. This is particularly true in the US market, where buybacks are much more prevalent than elsewhere. Unfortunately, buybacks are too often misunderstood or, even worse, completely ignored.
In that article, I presented a recent chart from investment bank Goldman Sachs. It’s reproduced below. Today I’m going to focus on the rate of earnings growth for S&P 500 companies.
Growth has been extremely strong over both the past 5 years and the past 15 years. The latter period includes the global financial crisis that began in 2007 (although most people didn’t notice it until 2008).
In the table included in that chart, the growth rates are rounded to the nearest percentage point. But the gaps (spreads) between the growth rates of earnings-per-share (EPS) and earnings are shown in basis points (bp). There are 100 basis points to a percentage point, so 100 basis points are the same as 1%.
Note that the growth rates are nominal, meaning unadjusted for inflation. I’ll come onto real (inflation-adjusted) rates later.
Using the spread figures, we can work out something close to the unrounded growth figures. These fall into potential ranges, but I’ll take the mid-points of the ranges for simplicity.
For example, in the fifteen years from 2003 to the end of 2018, this means nominal EPS grew around 10.8% a year and earnings grew around 8.2% a year. Adjusting for CPI inflation, which came in just under 2% a year, real EPS grew 8.7% a year and real earnings grew 6.1% a year.
You’ll notice from the table that earnings shot up by +18% in 2018. A large part of this was due to the cut in US federal corporate tax rates, which dropped from 35% to 21% last year. Since that is clearly a one-off effect, I’ve also calculated the figures for the four-year and fourteen-year periods to the end of 2017.
Below is a summary of the results.
The key figures to focus on are the ones in the box at the bottom right of the table. Real (above inflation) earnings growth was 5.3% in the 14 years to the end of 2017. In the four years to the end of 2017, real earnings growth was 3.6% a year. Both of these are well above real earnings growth for listed US stocks since 1900, which was around 1% a year.
What could have caused that? Has the US just been through a new golden age for capitalism? If so, is it likely to last?
One issue could be the systematic understatement of the government inflation data in recent decades. There are many vested interests who benefit from reporting a lower rate, and plenty of manhandling of the data before the official statistics are reported.
I’ve previously looked at this issue and concluded that consumer price inflation (CPI) is probably understated these days. My guess is that the understatement amounts to around 1-2% a year (see “Lies, damn lies and CPI”).
If we assume CPI actually averages 1.5% more per year than the official figures say, that brings down the real rates of earnings growth. For the fourteen year period it reduces to 3.8%, and for the four year period it’s down to 2% (both to the end of 2017, and thus excluding the one-off boost from 2018’s tax cuts).
But those figures are still well above the longer-term average of around 1% a year. So, whether or not CPI is understated, real earnings growth has been exceptionally high in recent times – even excluding the one-off lift from 2018’s tax cuts.
So let’s look at what may have caused that, and whether it can continue. Below is a discussion of some of the main factors likely to be in play.
A factor that could reverse
The obvious one here is the corporate tax cut. This boosted net profit margins. But competition is likely to reverse that effect over time in most sectors. Superior returns on capital rarely last long in market economies. The exceptions are likely to include businesses that operate as virtual monopolies (e.g. some of the biggest tech companies) or as regulated oligopolies (e.g. banks).
Factors that are likely to slow or stop
- Offshoring of jobs to low cost countries: this boosted bottom line profits in the past, but the wage differences and other cost advantages are no longer as big (especially with accelerating automation – see below).
- Creation of new tech monopolies / oligopolies: massive new US companies, often in brand new sectors, have sprouted during the start of the internet age (since the 1990s until now). Their global dominance has boosted earnings. That window may have now closed as others catch up (e.g. China), or governments seek to break them up.
- Ultra low interest rates and higher debt levels: The global financial crisis led to ultra-low interest rates. A great many US companies added leverage with little interest cost. Dollar interest rates are now closer to normal, although still on the low side. As more and more maturing debt is refinanced at higher rates, this will bite into earnings. In any case, the boost of rate cuts is well past.
Factors that are likely to continue but more slowly
- Globalisation of profits: huge US corporations have made more and more money outside the US. This is likely to continue, but there’s more international competition than before from corporations based in other countries (e.g. China).
- Mergers & acquisitions: Big companies have subsumed smaller ones, consolidating a bigger share of US corporate profits into the S&P 500 index. Low interest rates and increased debt have speeded this process. M&A won’t go away. But, eventually, there won’t be much more to buy.
Likely to continue and accelerate
- Productivity gains from job automation: This has been going on for many years, as technology replaces old jobs. It gets less political or media focus than offshoring jobs to other countries. But it’s probably had a bigger influence on corporate cost cutting and wage pressure in developed countries. Automation is rapidly moving from repetitive physical tasks (e.g. factory robots) to complex service industries (e.g. law, accounting, medicine, banking). Most technologists claim that this will result in better jobs for all. But it’s just as likely to result in far fewer well-paid jobs. In the meantime, early adopters of automation are likely to experience superior profit growth.
On balance, my feeling is that this superior real earnings growth is unlikely to continue. That means stock investors will need to be more selective to get decent returns in future, instead of just buying US index funds
Am I right? What have I missed? Please let me know what you think.
Stay tuned OfWealthers,