Every day we as investors are confronted with the dilemma of growth. If one of our portfolio companies announces that they are expecting even the slightest or most temporary slowdown then the stock price takes a huge hit. Or if an influential market prognosticator comes out with a prediction of slower growth in the economy then we seem inevitably on the outset of the next broad market sell-off. It all seems so silly. I am not saying that growth is not important. Clearly it is. The growth in earnings is the key component in projecting discounted cash flows. The growth of the GDP is a clear leading indicator of the stock market's direction.
The intent of this article is to make the case that longer term growth rates in the economy and corporate earnings have little correlation to long-term stock market performance and indeed demonstrate that there is some compelling evidence that the stock market performs better in a moderate growth environment than in a rapid and accelerating environment. Second, this article will provide several theories as to why this dichotomy of performance in the economy/corporate earnings and stock market performance should exist.
Growth Versus Stock Market Performance
Using data from the Yale.edu website created by Professor Shiller, I took snapshots of data at the beginning of each decade starting with the 1920s. I started with the '20s because this is generally regarded as the decade when reliable data for the S&P 500 originated. It is also the first full decade where the Federal Reserve allowed free money float and prices were allowed to inflate. Therefore, corporate earnings grew at a nominal rate that was not controlled by a static currency. The data is presented in the following table:
|Decade||Yield||Earnings Growth Rate||Payout Ratio||Average P/E||P/E at Decade Start||Compounded Return with Dividends|
It is interesting to see that the high return decades of the '20s, the '50s and the '80s all started with single-digit price earnings ratios ranging from 7.12 to 9.28. They also shared the distinction of coinciding with the later stages of commodity based inflation bubbles. Clearly expectations were low for stocks. In the '20s we had just come out of World War I and were in the later stages of a commodity inflation bubble. Similar to the 20s, the '50s began with low expectations after two decades of depression, war and rationing which created its own commodity bubble. The '80s began with a recession and 14% or higher long term Treasury Bond interest rates, soaring oil prices due to oil embargoes and gold prices that had inflated by a factor of over 20 in just over eight years.
Actually, in all cases, the excessive levels of pessimism were somewhat warranted. The ensuing earnings growth rates in all three decades were below average. I was most surprised by the data from the 50s. We have been told that U.S. corporations had a great decade because they had a huge tailwind from a cheap labor pool, high demand for their goods and services to rebuild the world's infrastructure, and little competition from Europe's depleted corporate sector. The data does not bear this out. Corporate earnings grew at the lowest rate of any decade other than the '30s.
In all three instances, clearly, the depressed levels of economic activity adversely impacted corporate America's ability to generate trend line growth. Yet, all three decades experienced compounded returns in excess of 15%. Clearly the level of pessimism manifested in the P/E ratios was too extreme. While corporations grew earnings at sub-par levels, the point must be made that they did indeed grow earnings. Things were not as bad as people feared. Those compounded earnings enabled the stock market to climb the wall of worry and reach normal price earnings ratios. It is important to note that it did not take extreme price earnings ratios to enable the market to generate such healthy returns. Simply a well-functioning market was sufficient.
Conversely, the two decades, the '40s and the '70s with the highest growth rates in corporate earnings produced sub-par returns. In fact, over 60% of the returns generated in those two decades were due to dividends. Stock prices themselves compounded very slowly. The economic climate was not favorable at the onset of either of these decades either. We were on the verge of or in wars on both occasions. And, yet, price earnings multiples were somewhat high in light of the challenges that were to be faced. It appears that those challenges were what set the stage for the outperformance of the ensuing decade as price earnings multiples were bid down.
It appears that the only decade where expectations and price earnings multiples were in sync was the '90s. A P/E of 14 seems like a reasonable price to pay for the high rate of growth that ensued. Unfortunately, as we all know, that story did not have such a happy ending.
We all want growth. However, the evidence from the numbers presented above makes a pretty convincing case that the market does a pretty good job of discounting current economic conditions. It rewards high past growth rates with high price earnings multiples. Conversely, it punishes uncertainty and past lethargy.
However, it appears that the market, as Ben Graham taught, really is not a very good long-term forecasting tool. It is that very lack of efficiency which seems to present great opportunity or great danger depending upon when you invest.