Prospects for the Stock Market: What Are the Fundamentals?

Another very telling excerpt from The Center for Economic and Policy Research that expresses my thoughts on the subject wholeheartedely. I can't vouch for the specific numbers, but the concepts of reversion to the mean in relation to corporate profit cycles and the outlook of the economy are right on the money - not to mention common sense.

In principle, prices in the stock market are supposed to reflect the future value of corporate profits. However, stock prices can get out of line with reasonable expectations of future profits, as they did in the late 90s. The ratio of stock prices to corporate earnings exceeded 30 at the peak of the market in 2000, more than twice its historic average. While the current price to earnings ratio in the stock market is not hugely out of line with its long-term average (it was 18.7 at the end of 20061), it appears as though 2006 was a cyclical peak for corporate profits. The capital share of corporate income in 2006 reached 20.8 percent in 2006, the highest share since the mid-sixties. (The after-tax profit share was 14.3 percent in 2006, slightly lower than the 14.5 percent share reached in 1997, the profit peak of the last cycle.) cles and the economy as a whole are right on point.

Profits do not remain at cyclical peaks indefinitely. In fact, profits appear to have already begun to decline from their 2006 peak.

Before-tax profits in the first quarter of 2007 were 7.2 percent lower than in the third quarter of 2006.2 It is reasonable to expect that over time, corporate profits will return to their long-term average as a share of corporate income. Based on this assumption, the Congressional Budget Office (CBO) projects that inflation-adjusted corporate profits in 2017 will be just 13.1 percent higher than in 2006.3 This implies a real growth rate of just 1.1 percent a year over this period.

1

This is calculated as the ratio of the market capitalization of U.S. corporations to the ratio of after-tax corporate profits. The former is taken from Federal Reserve Board, Flow of Funds, Table L.213, line 1. After-tax profits are taken from the Bureau of Economic Analysis, National Income and Product Accounts (NIPA), Table 1.14, line 11 minus line 12.

2

NIPA, Table 1.14, line 8.

3

This calculation is explained in the appendix. Center for Economic and Policy Research, August 2007 􀁺

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If the CBO projections are used as basis for calculating stock returns, it is necessary to believe that either price to earnings ratios will again rise to the bubble levels of the late 90s, or that investors are willing to accept returns that are far less than what they have historically received from owning stock.

Figure 1

shows the price to earnings ratios in the stock market over the years 2006 to 2017, if stocks provide their historic 7.0 percent average real rate of return, and the CBO projections for corporate profits prove accurate. In this scenario, the price to earnings ratio for the market as a whole will exceed 26 by the end of 2017. The only time that PEs reached this level since the 1929 crash was in the late nineties. In other words, if CBO’s projections for corporate profits prove accurate, the only way that investors will be able to gain their historic rate of return on stocks is if the nineties bubble re-inflates. This is not impossible, but probably not the most likely (or desirable) scenario. Furthermore, if PEs reached such an inflated level in 2017, then they would have to continue rising even more rapidly in future years to sustain a 7.0 percent real rate of return. By 2037, the PE ratio would have to be more than 45.

FIGURE 1 Figure has been deleted due to formatting issues.

Alternatively, it is possible to calculate the return that is consistent with the PE ratio remaining at its current level, and the profit growth projections from CBO. Assuming that corporations spend 60 percent of after-tax profits on either dividend payouts or share buybacks (approximately the recent average), then the real return that is consistent with a constant PE ratio is 4.3 percent. While this is somewhat higher than the 2.7 percent real return available on inflation indexed government bonds (an extremely safe asset), it seems unlikely that most investors would be willing to hold stock for such a 1.6 percentage point premium over government bonds. In other words, if the CBO profit projections prove correct, current stock prices seem inconsistent with rates of return that investors would view as acceptable. The stock market may not be as over-valued as it was in the 90s, but the CBO profit projections imply that investors in the stock market will fare poorly given current prices.

Of course, CBO may prove to be overly pessimistic in its profit growth projections. However, the assumption that profits return to cyclical averages is a reasonable one. It is possible that profits will be a somewhat higher share of income in the future than in the past or that overall economic growth will be faster than projected by CBO. But, it is unlikely that profit shares will remain near their

cyclical peaks indefinitely or that growth will be substantially higher than the rate projected by CBO. In order for stocks to yield a 7.0 percent real return with a constant PE, profits would have to be almost 40 percent higher in 2017 than projected by CBO. Given the credibility that CBO’s projections are given in other contexts, it would be extraordinary to assume that it could be so far off on such an important economic variable. Furthermore, if profit growth turns out to be substantially more rapid than CBO has projected, it would be necessary to make adjustments to CBO’s projections for tax revenue, budget deficits, Social Security, and the finances of other programs, especially if the upward adjustment is due to more rapid economic growth.

The underlying point here is that projections for the stock market must be tied to projections for the profit growth, which are in turn embedded in projections for economic growth. Over the short-term, the stock market is driven by psychological factors and there is no necessary link between good or bad profit news and movements in stock prices. However, over the long-term, the stock market must bear a relationship to fundamentals, specifically profits.

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The fact that analysts generally did not look at the fundamentals when discussing the market in the nineties, or again when the market became over-valued in the current decade, is a serious failing. Many workers and taxpayers will be hurt by this failure when public and private pension funds face shortfalls as a result. In addition, many workers are likely to enjoy less comfortable retirements because they relied on advice from analysts who did not bother to do their homework.