February 25, 2020
In spite of completely missing the crash of the stock bubble in 2000-2002 and the housing bubble in 2007-2010, people tend to think that the big actors in the stock market have great insight into the economy’s prospects. While I won’t claim to have a crystal ball that predicts the future of the economy (I had warned of both of those crashes), I did learn arithmetic in third grade.
There are some simple and important statements we can make about future stock returns, based on nothing more than arithmetic and the generally accepted projections for the economy’s performance. The basic story is that if we accept the projections for future profit growth from the Congressional Budget Office or other official forecasters, then we are almost certain to see a decade of extraordinarily low returns to stockholders.
Real returns will almost certainly be less than 5.0 percent annually. This compares to a long period average of close to 7.0 percent. And this assumes no plunge in the market over the decade. Of course, if the market does plunge, real returns will be considerably lower.
The reason that returns will almost certainly be low in the next decade is that stock prices are high. If we look at Robert Shiller’s calculations of the price of the S&P 500 relative to ten years of trailing earnings, it was at 31.5 for February to date. That compares to an average of 20.6 in the 1960s, 12.7 in the 1970s, and 11.5 in the 1980s. A high price to earnings ratio means that people buying or holding stock are paying a high price for each dollar of earnings.
To see what this means more concretely, we can take the most recent price to earnings figures from Shiller’s data. Taking February’s prices over December’s earnings, we get a ratio of 23.7. Taking a somewhat broader, but somewhat dated measure, the value of all corporate equities was $49.6 trillion at the end of the third quarter. After-tax corporate profits were $1,869 billion, giving a price to earnings ratio for the market as a whole of 26.5.[1]
The fact that these two figures are close should give us confidence that we are looking at the right numbers. It would not be surprising that the whole market would have a higher PE than the S&P 500. The index is by design composed of older well-established companies. Many smaller and newer companies may have high valuations based on growth prospects rather than current profits.
Anyhow, we can work from the slightly lower PE reported by Shiller for the S&P 500. The ratio of 23.7 implies an earnings-to-price ratio of 4.2 percent. This means that for each dollar a shareholder is paying for stock, they get 4.2 cents in earnings.
Companies pay out a portion of their earnings to shareholders as either dividends or share buybacks. (There are some differences between these mechanisms for tax purposes, but that really does not matter for this analysis.) Suppose that they pay 70 percent of their profits out to shareholders, which would be the high end of the recent range. This would mean that shareholders could get annual returns from direct payouts of 2.94 percent (0.7 * 4.2).
The other component of returns is capital gains. The actual course of the market over the next decade is anyone’s guess, but one thing we can say with absolute certainty is that if the price to earnings ratio remains constant, then share prices will rise at the same pace as corporate profits. And, we do have projections for the growth of corporate profits over the next decade.
The Congressional Budget Office projects that before-tax corporate profits will grow at an average annual rate of 4.15 percent over the decade from 2020 to 2030. It makes sense to use before-tax profits because we don’t know what will happen to the corporate tax rate over this period. The 2017 tax cut hugely reduced corporate taxes, however, it is possible that if Trump is re-elected he will seek to reduce corporate taxes even further. On the other hand, all the leading contenders for the Democratic presidential nomination have pledged to raise corporate taxes, in most cases by quite a bit. Without knowing the outcome of these political battles, it is probably safest to assume the tax rate remains where it is currently.
This gives us an average annual nominal capital gain of 4.15 percent. The average inflation rate projected for this period, as measured by the consumer price index, is 2.4 percent, which gives an average real capital gain of 1.75 percent. If we add that to the 2.94 percent return from dividends or buybacks, it comes to 4.69 percent. This is considerably below the 7.0 percent historic real return on stocks, that many investors bank on.
Of course, these are very crude calculations. No one knows that the price to earnings ratio will stay stable. Suppose it were to keep rising enough to give 7.0 percent real returns over the next decade. In that case, using the CBO profit projections, the price to earnings ratio for the S&P 500 would be over 30 by 2030. That is not obviously impossible, but the 70 percent dividend/buyback payout would get shareholders just 2.3 percent of the share price. That would mean to sustain a 7.0 percent real return, price to earnings ratios would have to rise even more rapidly in the following decade.
The situation would look even worse with the broader market. Starting with a price to earnings ratio of 26.5 to 1, the price to earnings ratio for the market as a whole would be over 35 by 2030. That would provide a dividend/buyback payout of just 2.0 percent.
It is possible that profits could grow more rapidly. For example, the Trump administration could be proven right and maybe we will see 3.0 percent real growth over the next decade, but there are not many people betting on that being the case. We could see a further shift to profit shares, although, with profit shares already at an unusually high level, that does not seem likely. There could be further cuts in corporate taxes, but with the effective corporate tax rate projected at less than 11.0 percent in 2020, that seems unlikely even if the Republicans remain in power. In short, it seems almost inevitable that real stock returns over the next decade will be considerably lower than their long period average of 7.0 percent.
However, the 4.7 percent real returns that would be consistent with a constant price-to-earnings ratio is not necessarily bad in the current interest rate environment. Historically, the real return on long-term Treasury bonds has been close to 3.0 percent. By contrast, the current interest rate on a 30-year Treasury bond is roughly 2.0 percent, putting it slightly under the inflation rate. A 4.7 percent real return on stocks does not look bad in a context where the long-term Treasury bonds are providing a zero or small negative real return.
But even if a 4.7 percent real return might be reasonable in the current interest rate environment, it is not clear that it is consistent with investors’ expectations. Many investors are undoubtedly looking at the far higher returns of the years since the Great Recession and expect double-digit returns to continue for at least the immediate future. They may be very disappointed if this turns out not to be the case.
The other part of this story that stockholders have to consider is that there are good reasons for thinking that future after-tax profits might be considerably lower than CBO has projected. On the before-tax side, there was a large shift in income shares from labor to capital in the immediate aftermath of the Great Recession. As the labor market has tightened, there has been some shift back towards labor. The CBO projections assume that this reversal does not continue. In fact, the projections assume that the profit share of national income actually increases slightly over the decade.
The other key factor in determining after-tax profits is the corporate tax rate. This is, of course, a political decision. While Republicans are unlikely to raise corporate income taxes to any substantial extent, they also are unlikely to lower them further. By contrast, there is widespread agreement among Democrats that corporations should pay more in taxes. Whatever the outcome of the 2020 elections, there is at least a reasonable prospect that corporate taxes will increase at some point over the next decade.
With the possibility of further shifts back from capital to labor and future increases in the corporate income tax, stockholders should view their investment as somewhat risky. If the labor share were to rise back to its pre-recession level, profits would drop by 10 percent, if price to earnings ratios were unchanged. That would wipe out more than two years of returns, as calculated above.
The same would be true if there was a 9.0 percentage point rise in the effective tax rate to 20.0 percent, roughly the level prior to the 2017 tax cut. That would also lead to a 10 percent drop in share prices, assuming a constant price to earnings ratio.
And, the interest rate on government bonds could rise. Most economists have been surprised that long-term interest rates have remained this low for as long as they have. The low rates could continue, but no one can rule out that they will rise back to their historic average of 3.0 percent real rates. If that were to be the case, a 4.7 percent real return in the stock market may not look very good.
In short, there are good reasons for thinking that the current valuations in the stock market are high. That doesn’t mean that prices will plummet any time soon, but it does seem unlikely that anything like the recent growth will continue far into the future.
[1] The value of corporate equities comes from the Federal Reserve Board’s Financial Accounts of the U.S. Economy, Table L. 223, Line 10. After-tax corporate profits are taken from the Bureau of Economic Analysis’ National Income and Product Accounts, Table 1.12, Line 15.
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