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The lost decade for US profits

The S&P 500 index of US stocks plummeted during 2008 and 2009 as the financial crisis struck. Then it performed extremely well between early 2009 and early 2015. But surprisingly little of this performance can be justified by profit growth. Unless US corporations can return to growth, US stocks look dangerously overpriced.

A recent article by Bloomberg pointed out that the S&P 500 index of US stocks had returned 10.8% a year since 1980, on average. The suggestion was that investors should just follow the advice of famous investor Warren Buffett, and leave most of their portfolio invested in the main US index. Over time this should give them decent returns.

But it got me thinking, and I wanted to do some more digging. Specifically I wanted to know how much of that came from the underlying businesses – in the form of profit growth and dividends – and how much was just an increase in valuation multiples such as the price-to-earnings ratio (P/E).

Just because returns have been good over the past 35 years doesn’t mean that performance will be repeated in coming years and decades. And when mainstream media or brokers are cheerleading for something that’s when we need to be most sceptical of their claims.

You see, 10.8% a year is quite a bit more than the long run average. I had read in a study by Credit Suisse that the long term return from US stocks was 9.5% a year in the 114 years between the start of 1900 and the end of 2013.

I also knew that US stocks were relatively cheap in the early 1980s, and are relatively expensive now, both compared with their historic averages. See here for more on the current, expensive situation.

To understand the total return from stocks and what’s likely in future it helps to analyse what’s happened in the past. One approach is to break down total return into its component parts.

First we can split the profits between dividend income and stock price changes (capital gains or losses). Stock prices are a function of a valuation multiple applied to a financial measure of the company.

To keep it simple I’ll stick to earnings based measures. So the relevant valuation multiple is the price-to-earnings (P/E) ratio, and the financial measure is earnings-per-share (EPS), which is company profit divided by number of shares issued.

Price is P/E multiplied by EPS. EPS itself rises over time partly due to general increases in the prices of goods and services – in other words due to inflation. EPS growth on top of inflation is known as real EPS growth. EPS growth including inflation is known as nominal EPS growth.

Those are the component parts of total returns from stocks. As I said before the total return on US stocks between 1900 and 2013 inclusive was 9.5%. Let’s now break that out.

Over that 114 year time span the P/E increased 43% from 12.71 to 18.15. But because that change was spread over such a long time frame it works out at just 0.3% a year.

In other words the remaining 9.2% a year profit came from what the underlying companies actually did, and not from a change in the overall stock market valuation level. I’ll call that the “business return”.

It breaks out further as 4.4% a year from dividend income and 4.8% a year nominal EPS growth. EPS growth can be split between 3% a year from average inflation and 1.8% a year real (above-inflation) EPS growth.

This helps explain why stocks are good long term investments, most of the time. Over the long run the total returns have easily outstripped inflation, although of course there were taxes to pay. It’s the expectation that companies will continue to comfortably grow their EPS above inflation, and pay dividends on top, that keeps people investing in stocks. The higher returns make up for the higher risk, as opposed to, say, cash deposits.

Clearly it’s not plain sailing all the time. Sometimes profits and EPS grow strongly above inflation. Other times they don’t.

The weakest real EPS growth was in the 1930s. That’s no surprise since it was the Great Depression. The strongest period was in the decade to 1955. Again no surprise, since it followed the second world war, when the US was riding high and Europe was on its knees.

The following chart looks at real EPS growth for all five year periods since 1940. You can see straight away that it’s been pretty weak in recent years, even if some other periods were worse.

s&p-500-real-annual-EPSReal EPS was -0.1% a year in the five years to 2010. That’s perhaps no surprise given that it included the financial crisis of 2007 to 2009. But then it was just 0.7% a year in the five years to 2015. That’s a pretty pathetic “recovery”, with real EPS growth running at just 40% of the long term average.

Banks may have been struggling – and more recently energy and commodity companies. But at the same time other sectors have grown strongly, such as healthcare and technology.

Banks may have been struggling – and more recently energy and commodity companies. But at the same time other sectors have grown strongly, such as healthcare and technology.

And yet we know that the S&P 500 index performed well during that period. The total annual average return over the five years from end 2010 to end 2015 was 10.4% a year. Inflation was a low 1.7% a year. Real EPS growth was a low 0.7% a year. Dividends were a low 2.1% a year.

That means a massive 5.9% a year came from multiple expansion. In fact the P/E went from 16.3 in December 2010 to 22.2 by December 2015, up 36%.

Given poor EPS growth this can only have come from one thing: the bubble blown by the Federal Reserve’s policies of ultra low interest rates and quantitative easing (printing money to prop up financial markets).

Either that or investors are incredibly optimistic about the future trajectory of US corporate EPS growth. Based on the evidence of the past 10 years, and what we know about the state of the world in general, it’s difficult to see why they would be.

This next chart compares sources of US stock investor profit from the 1900 to 2013 period with both the last 10 years and the last five years.

S&P-500-components-of-returns

Clearly the returns from multiple expansion – the P/E increase – have been a huge factor in recent years. Over the long term this is unsustainable. Multiples are already high and can’t keep increasing forever.

In fact, excluding the (unrepeatable) multiple expansion, total profit was only 4.5% a year over the past five years, and just 2.8% once inflation is stripped out. That compares very poorly with the long term average of 9.2% total business return and 6.2% real business return (above inflation).

This is also worrying given that we know US corporations have been spending huge amounts of money on stock buybacks. That should increase EPS since earnings are split across fewer remaining shares. I’d expect it to prop up real EPS growth by at least 1% a year, and as much as 3%.

In the old days companies would have spent more company cash on dividends – as the chart suggests. But nowadays buybacks are a quick and widely accepted route to management riches, even if it means looting the company at the expense of future profit growth (see here for more).

…as fast as corporations have been cancelling stock, they’ve been busy issuing new stock to management and employees.

The implication is that, as fast as corporations have been cancelling stock, they’ve been busy issuing new stock to management and employees. This “dilution” has taken money from existing outside shareholders and transferred it to corporate insiders.

Whatever is happening, it’s been a lost decade for US corporate profits. Real EPS growth – above inflation – has been pathetic. Unless that changes fast – and I see no reason why it should – then US stocks are living on borrowed time. Big price falls are likely as more and more people realise what’s going on.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.