A few weeks ago, the "Economic Scene" column in the NY Times reported on a paper of Dean Baker of the Economic Policy Institute, a liberal think tank. The purpose of Baker's paper was to oppose investing Social Security money in the stock market, but his arguments are relevant to investors generally.
Baker points out that the superior returns in the stock market in the last 70 years (he says 7% real return) have been far in excess of the 2% or so annualized growth in the GDP. This extra return has two components - first, corporate profits as a percentage of sales have grown considerably, mostly at the expense of wages. Second, P/E ratios have also risen substantially. His paper goes on to discuss why these trends have natural limits.
The market's P/E is now roughly 20. If profits stay stable as a percent of revenues, then the P/E will have to rise to 34 by 2015 in order to sustain that 7% return. Conceivable, but it is a Ponzi game - people buying in 2015 will have to expect even higher P/E's to get a 7% return (Baker calculates the market P/E must reach 485 by 2070.)
I'll add my own argument to the P/E issue. People forget that high P/E's set the stage for their own undoing. A booming stock market makes it easy for companies to start up, raise money and expand. These extra companies (and expanded activities of existing companies) are initially a source of demand in the economy, as they spend the money that they have just raised on equipment and employees. But they also represent an expansion of supply, and become competition for other companies. High P/E's eventually result in the creation of too many companies, and when too many companies compete for limited business, that leads to price wars, margin squeezes, bankruptcies and economic weakness.
What very few people realize is that the role of the stock market in the economy is primarily as an information mechanism, to direct capital where it is needed and away from where it isn't. High P/E's are the stock market's way of telling us that profit prospects are favorable, we need more capacity.
But we don't always need a lot more capacity - when rising profits and a rising stock market have done their job of helping companies expand, then they move onto their next job, discouraging further investment in industries where supply is now adequate. This message is conveyed by declining profits and a bear market. I'm not sure whether Baker mentioned or even noticed the contradiction, but high stock prices in the long run are incompatible with rising profits - the party is fun only while it isn't too crowded.
On the other hand, if the market P/E just remains at around 20, then in order for the stocks to sustain a 7% growth rate in an economy growing by 2%, corporate profits are going to have expand even further at the expense of labor. He calculates that average wages will have to fall by 1/3 over the next four decades. That seems contradictory because employees are needed as consumers to provide the sales and profits.
An escape from this trap might be possible if corporations could earn increasing amounts from overseas markets. Then profits could rise faster than GDP. The problem is that foreign and export profits are too small at present for any plausible growth rate to allow it to take up the slack. And I would imagine that a world in which the US economy is booming internally and exporting like mad might also be a world in which the dollar would get very strong versus other currencies, limiting exports and foreign earnings.
Also, if you imagine changes in society or technology that would somehow generate substantially higher real GDP growth, then you also have to assume that the rising demand for capital associated with that growth would presumably send real interest rates a lot higher, to the detriment of P/E's.
So if Baker is correct it is hard to see the stock market growth averaging more than a few percent. It sounds like a relatively airtight case, but it might easily have been made a couple years ago, and those who acted on it by selling stocks and, perhaps, buying bonds, would have regretted it.
Thoughts, anyone? |
