November 14, 2003

How Fast Will Profits Grow?

The Economist appears to think that the American stock market is overvalued:

Economist.com | America's business recovery: ...Although executives now feel under less market pressure since the discrediting of the Wall Street sell-side analysts who pushed them to have ever-shorter time-horizons, they still hear the market's call. And the current stockmarket rally has pushed the Dow Jones Industrial Average back towards 10,000, where it last stood in May 2002.

As investors' expectations about future profits growth are inflated by rising share prices, a "natural pressure build"?, says Jim Andrews of the Boston Consulting Group. In lean times, says Mr Andrews, firms tend to invest fewer of their R&D dollars in new "breakthrough"? products or services. Their spending is focused instead on maintaining the competitiveness of existing products. By its nature, restructuring diminishes future opportunities for growth.

This makes the current expectations of investors in American shares look all the more unrealistic. Analysts are forecasting that corporate profits will grow by some 11% a year for the next five years. But the long-run performance among S&P 500 firms is only 7% a year. Few of America's top managers, however, yet seem to be in a mood to take on the kind of extra risks which might meet inflated growth expectations, or beat the long-term trend, until they feel confident that restructuring has indeed dealt with all the excesses of the late 1990s. And here the picture is patchy. Industries such as telecoms and business software appear to need still further consolidation. Indicators of capacity utilisation--a measure of how fully businesses are using existing plant and people--suggest that much overcapacity persists...

Posted by DeLong at November 14, 2003 11:59 AM | TrackBack

Comments

I agree with The Economist on this one. Okay, I admit that I'm a perennial bear, but there was a time about a year ago when stocks looked reasonably priced to me. No more. I think that there's no way that current valuations are justified. Especially since (as I've noted elsewhere) I think that the economy is going to slow down in 2004, not pick up.

Posted by: Kash on November 14, 2003 12:53 PM

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With regards to analyst forecasts for earnings growth, 11% seems quite conceivable considering they are coming off depressed numbers from the past two years. There was plenty of "washing of the decks" that took place giving S&P companies lean financial statements. Thus, any slight uptick in top-line numbers will certainly lead to hefty growth rates. To note, there is no reason to but much faith in forecasts more than a quarter in advance. There is a study by the Atlanta Fed that looks at the success of economic forecasts.

As for P/E multiples, the 12-month forward P/E's of the major indices are trading above their post-1987 averages. However, once interest rates begin to tick up, these multiples will start to come back down because of the nature of the formulas used to get a P/E ratio.

The market is pricing in around 11% growth, but this is below the post-1987 S&P average growth rate of 15%. Not sure what time period the Economist uses to get 7%. In this case, though, the market has room to move up. The only big question we should ask is whether certain sectors of the economy are overvalued, not necessarily the whole market.

Posted by: NP on November 14, 2003 02:26 PM

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With regards to analyst forecasts for earnings growth, 11% seems quite conceivable considering they are coming off depressed numbers from the past two years. There was plenty of "washing of the decks" that took place giving S&P companies lean financial statements. Thus, any slight uptick in top-line numbers will certainly lead to hefty growth rates. To note, there is no reason to but much faith in forecasts more than a quarter in advance. There is a study by the Atlanta Fed that looks at the success of economic forecasts.

As for P/E multiples, the 12-month forward P/E's of the major indices are trading above their post-1987 averages. However, once interest rates begin to tick up, these multiples will start to come back down because of the nature of the formulas used to get a P/E ratio.

The market is pricing in around 11% growth, but this is below the post-1987 S&P average growth rate of 15%. Not sure what time period the Economist uses to get 7%. In this case, though, the market has room to move up. The only big question we should ask is whether certain sectors of the economy are overvalued, not necessarily the whole market.

Posted by: NP on November 14, 2003 02:29 PM

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With regards to analyst forecasts for earnings growth, 11% seems quite conceivable considering they are coming off depressed numbers from the past two years. There was plenty of "washing of the decks" that took place giving S&P companies lean financial statements. Thus, any slight uptick in top-line numbers will certainly lead to hefty growth rates. To note, there is no reason to but much faith in forecasts more than a quarter in advance. There is a study by the Atlanta Fed that looks at the success of economic forecasts.

As for P/E multiples, the 12-month forward P/E's of the major indices are trading above their post-1987 averages. However, once interest rates begin to tick up, these multiples will start to come back down because of the nature of the formulas used to get a P/E ratio.

The market is pricing in around 11% growth, but this is below the post-1987 S&P average growth rate of 15%. Not sure what time period the Economist uses to get 7%. In this case, though, the market has room to move up. The only big question we should ask is whether certain sectors of the economy are overvalued, not necessarily the whole market.

Posted by: NHP on November 14, 2003 02:30 PM

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"As for P/E multiples, the 12-month forward P/E's of the major indices are trading above their post-1987 averages. However, once interest rates begin to tick up, these multiples will start to come back down because of the nature of the formulas used to get a P/E ratio."

Please explain???

Posted by: anne on November 14, 2003 02:30 PM

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I am bullish, but this is an expensive market unless I have forgotten how to use numbers. P/E ratios for the S&P are about 21 excluding losses and 28 including losses. These are trailing P/E ratios and earning will be decent, but this is an expensive market. So, I am bullish but becoming more cautious.

Posted by: anne on November 14, 2003 02:34 PM

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Anne:

Not sure what to explain. The quote relied on formulas whatever that means. Stock values are not driven by mathemetical equations so if the author was saying simply because some attempt to simply model the fundamentals of the market drives the market, the author is nuts. Now maybe the author meant to say that market values depend on expected future cash flows (proxied by earnings) relative to the cost of capital. But then he'd be stating what you likely already know. As I hesitate to criticize his writing style - as I'm sure my is worthy of a critic as well.

Posted by: Hal McClure on November 14, 2003 02:48 PM

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Hal,
oh you were doing all right up until your last sentence :)

Posted by: Patrick (G) on November 14, 2003 02:59 PM

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"my is worthy of a critic"

Shame on you!

Posted by: john c. halasz on November 14, 2003 03:22 PM

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What about this story:
http://www.usatoday.com/usatonline/20031114/5681241s.htm

"Taxpayers' refund checks will increase nearly 27% to an average $2,500 per family early next year, according to new forecasts from tax experts and economists, who say the windfalls will aid consumers, the economy and President Bush's re-election campaign."

The story is nearly unintelligible. I think it says that there are people who did not get refunds during this year and who will get them next year. It may also say that there are about 8mm of them. The rest of the explanation may be that many people will get higher refunds than expected because they did not adjust their withholding during the year to reflect the tax cuts. Anyway, it says that there is a bunch of money poised to come into the economy in the first part of the year and that will help the economy.

Posted by: Masaccio on November 14, 2003 03:45 PM

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Let me inject a note of scepticism about the statement made by NP that "the market is pricing in around 11% growth, but this is below the post-1987 S&P average growth rate of 15%." Remember that a lot of that 15% growth rate in profits happened in the late 1990s... and turned out to be accounting fraud. Tens of billions of dollars of profits have now been revealed to never have existed. That this was a substantial phenomenon can be seen by looking at the US's national accounts. According to the BEA, profits in the US were in reality MUCH lower during the latter half of the 1990s than what you get if you add up individual firms' profit reports.

Regarding the USA Today story: those figures mean that the average family will only get about $500 more next year from the tax cuts. Is $500 per family really enough to make a big difference? I'm doubtful. Then consider the inequity of that $500. That average includes a few million people getting several thousand dollars, and another 100 million people getting maybe two hundred dollars or less. Again, I'm sceptical that economic growth can be sustained by money that is mostly going to be available to only a small fraction of the US population.

Posted by: Kash on November 15, 2003 04:49 AM

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Whenever I hear a comment that stocks are "overvalued" or "undervalued" on the order of 10% or 20% I want to ask: how can you possibly measure these values so precisely? The very purpose of commmon stock is to absorb the uncertainties at the margin of a company's performance. It's an instrument structured to magnify variability. To appraise commercial real estate, with no such structuring going on, within tolerances of 10% or 20%, would be considered very good indeed.

Posted by: Cartographer on November 15, 2003 05:41 AM

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The long run trend of s&p earnings growth since
WW II has been 7%. Interestingly if you calculate the current PE on the basis of trend 7% eps
-- a form of normalized earnings -- the PE is about 17, or about the same as it was in the early 1960's when inflation and interest rates
were at roughly current levels.

I disagree strongly with Hal, stock prices are driven strictly by formulas. The PE is an expression of the current value of the future stream of income you expect. it is a function of interest rates, inflation, monetary policy and the risk premium. For large cap stocks like the S&P 500 the PE is just a special case of the
dividend discount model. Yes, the actual PE does deviate significantly from what the formula calls for at times. But the deviation is a sell or buy
signal because it is telling you the market is overvalued or undervalued and is going to go back to the other extreme. If you stick to the discipline of using a formula to establish a reasonable value for the PE and act when the actual PE deviates you can "market time" and improve your results. The big unknown in calculating a formula for the curent PE is what should the risk premium be. Bears argue that the risk premium is too low and it has to go back to historic norms, so mkt is overvalued. But there is an economic argument that because system is now more stable than it use to be -- measured by frequency and duration of bear mkts -- that a lower risk premum is justified and no reason to think it should have to go back to historic norms. On the baisis of this argument the S&P 500 is fairly value or cheap.

Moreover, the market is driven almost exclusively by changes in valuation. The belief that earnings drive the market is more an urban myth than fact.
From 1949 to 2000, the period of the great bull market, EPS accounted for 21% of increase in S&P
and change in valuation accounted for 79%. From 1949 to 1961 EPS only accounted for 10% of S&P increase. From 1961 to 1975 EPS rose almost 150%, but S&P fell. From 1975 to 2000, EPS only accounted for 25% of S&P increase.

The correlation between the change in the market and the change in EPS is -0.004 -- i,e, it is essentaily random and EPS contains no useful info that help you tell what the market is likely to do next. Even if you use a perfect forecast of next years EPS the correlation s still only 0.2 -- you would still be better off flipping a coin than using a perfect eps forecast. But the PE and MKT move in the same direction of mkt over 90% of time. If you can be right on direcion of PE you can be right about direction of mkt over 90% of time.

The most valid earnings number is probably somewhere between the "reported" and "operating" eps number and it is probably closer to the operating number than the reported data. The two numbers are now converging and are expected to have only slight differences next year.


Posted by: spencer on November 15, 2003 06:16 AM

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Interesting comments. I continue to be bullish, but this market is historically expensive. There is no reason the market can not trade at these and higher levels, especially given the tax benefits of stock dividends and capital gains, but I expect future gains will average quite bit less than what we have seen this year unless you assume the market ought to trade at a trailing P/E above 25 excluding losses. Again, I am bullish but more moderately and happily prone to look toward better company valuations here and abroad.

The average tax gain next year must be broken down by income class. The middle class gain may be far less than $500. Remember, the tax cuts slant ever more strongly to the wealthiest. We need numbers.

Posted by: anne on November 15, 2003 11:05 AM

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spencer,

Interesting analysis. We all know that stock prices go up either by increases in future cash flow expecations or decreases in future expected returns (the discount rates used to NPV those cash flows). Of course, financial economists since Shiller in his 1981 paper have shown that changes in discount rates (risk premiums) affect stock prices much more than changes in cashflow growth expectations. This is pretty much what you reassert here.

The question is: do you think TODAY's stock market is rich or cheap GIVEN the new discount rates? If it's fair, do you think the new discount rates are "reasonable" or sustainable? Many investors in today's economy are holding a lot of cash and are satisfied with making 6% returns. This causes stock prices to rise. How long will people be satisfied with a mere 6%?

MG

Posted by: mg on November 16, 2003 06:28 AM

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Actually, my equation for the current PE, that assumes a lower risk premium is justified, current
inflation and bond yields, as well as real mzm growth and free reserves as measures of fed policy imply that a market PE on trailing operation earnings of 20-21 is fully justified.

From 1960 to 1990 a simple formula of 21 - fed funds was a great PE equation. The problem is that the relationship between PE and rates and inflation shifted during the 1950s, was stable from 1960 to 1990, and shifted again in the 1990s. I believe this was because of the fall in the risk premium because the system is more stable
now than it use to be.

I published an article in the spring edition of Business Economics that explains my fair value PE.

Posted by: spencer on November 17, 2003 12:13 PM

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