On the Other Hand

Jonathan Clements

YOU COULD ARGUE that U.S. stocks are reasonably priced, with the S&P 500 companies trading at 22 times their reported earnings for the past 12 months. That’s not much above the 50-year average of 19.3—and hardly outrageous, given today’s modest bond yields.

But you could also argue that U.S. shares are horribly overpriced. The S&P 500 stocks today offer a dividend yield of just 1.9%, versus a 50-year average of 2.9%. Shares also seem pricey compared to both the value of corporate assets and average company profits for the past 10 years.

What’s the truth? This past week, I updated many of the numbers in the financial markets chapter of HumbleDollar’s online money guide. Those numbers offer some perspective on today’s valuation conundrum—and on what sort of stock returns we might see in the decades ahead. Consider six points:

1. Over the past 50 years, nominal U.S. economic growth averaged 6.4% a year, per-share profits for the companies in the S&P 500 rose 6.5% and the S&P 500 climbed 6.6%, excluding dividends. Meanwhile, annual inflation ran at 4%. The simplistic explanation:  A growing economy drove up corporate profits, which—in turn—propelled share prices higher.

2. Look more closely, however, and you might wonder why per-share corporate profits didn’t grow even faster. Over the past 50 years, after-tax company earnings received two big boosts. First, the top corporate tax rate fell from 52.8% in 1968 to 21% today. Second, the share of GDP claimed by after-tax corporate profits rose from 6.5% to 9.3%. Because of falling tax rates and rising profit margins, after-tax corporate earnings should have grown faster than GDP.

3. Why didn’t earnings grow more quickly? The twin benefits of falling taxes and rising margins were offset by dilution—one of the most insidious threats to owners of publicly traded companies. As corporations issue new shares and as new businesses emerge, existing shareholders see their claim on the economy’s profits gradually diluted. This dilution has been estimated at two percentage points a year—meaning that, if overall profits rise 6% a year, the per-share profits of publicly traded companies might climb just 4%.

4. A funny thing happened to dilution over the past decade: It disappeared, thanks to stock buybacks. For instance, during the 12 months ending September 2018, the S&P 500 companies spent $446 billion on dividends and $720 billon repurchasing their own shares. That’s more than the $1.1 trillion they reported in earnings, according to S&P Global. The sum spent on buybacks was equal to 2.9% of the S&P 500’s market value. That means the shares repurchased by companies were greater than the historical 2% dilution rate—good news for shareholders.

5. Or is it bad news? If corporations are spending more on buybacks and dividends than their reported earnings, does that mean these companies are skimping on capital spending—to the detriment of long-run earnings growth? Or do companies feel less need for capital spending, because they anticipate slower growth in the years ahead?

6. Real GDP grew an impressive 2.8% in 2018, a tad above the 50-year average of 2.7%. Last year, however, may be an aberration. GDP growth since 2000 has averaged a pedestrian 1.9%—with good reason. The economy grows as we both increase the number of workers and increase their productivity. Lately, growth in the workforce has slowed, with the millennials entering the workforce barely outnumbering the baby boomers who are retiring. The labor force is projected to grow just 0.6% a year over the decade through 2026, versus an average of almost 1.5% for the past 50 years.

Where does all this leave us? The S&P 500 companies are returning huge sums to their shareholders. It just happens that they’re doing so by buying back shares, rather than through dividends. That suggests we probably shouldn’t be alarmed by today’s modest dividend yields.

But that doesn’t mean I’m greatly comforted by today’s price-earnings ratio of “only” 22. Last year, the S&P 500 companies’ reported earnings surged 20%. But that entire increase can be explained by the drop in the corporate tax rate—a onetime gain that could easily be reversed. Moreover, in the decades ahead, relatively modest economic growth seems almost inevitable, given the expected sluggish growth in the workforce. The danger: Investors are disappointed by corporate earnings growth—and decide that today’s lofty stock market valuations aren’t justified.

But even with the risk of a large short-term market drop, I think stocks remain the best bet for long-term investors. U.S. shares may be richly priced. But those who diversify globally will also have cheaper markets in their portfolio. And let’s face it: With 10-year Treasury notes yielding less than 2.6%, is there any alternative to biting the bullet and buying stocks?

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Five CrashesMoney Matters and 45 Steps to Success. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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