Quite often, our articles follow a similar format. We start with a “hook” to grab your interest and then offer a summary of what’s to come. Next comes the meat of the article, with data, graphs and a discussion that supports our view on the subject matter. Our closing summary typically encapsulates the main takeaways along with investment implications if applicable. A quote or two along the way never hurts.
In this article, we take a different tack. We present and analyze the factors that drove the bull market to record highs over the last nine years. It is these same factors that will also determine where the market will head in the coming years. However, instead of stating our opinions and giving a market forecast, we leave that to you. This approach will not only allow you to estimate the future price of the S&P 500, but importantly prove valuable in helping you understand the forces that drive market prices.
Foundations of the Bull
Valuing a stock or an index may seem complex, but there are only two factors that account for the price and its performance – estimates of a corporation’s future cash flows and the factor, or multiple, investors are willing to pay for those cash flows. While this does not occur neatly in a program or spreadsheet as the description might imply, the performance of every stock and index can be decomposed into those simple pieces.
With that in mind, we turn to the current U.S. equity bull market which started in the shadow of the financial crisis of 2008/09. The 315% rally, which might celebrate its tenth anniversary in March of 2019, is the longest uninterrupted equity expansion in modern U.S. history. Given the extended duration of this rally, it is more important than ever to look forward and not assume yesterday gains will continue tomorrow.
The following two sections look at corporate cash flows and valuation multiple trends on the S&P 500. This historical attribution analysis offers context and perspective about how those trends may or may not change going forward and ultimately what that means for the price of the index.
Corporate cash flows that accrue to investors should be dissected into two components, revenues (sales) and profit margins.
Not surprisingly, corporate revenues are highly correlated with economic growth. Since 2010, aggregate revenues of the S&P 500 grew by 35.7%, while GDP grew by a similar 38.6%. The graph below shows the tight correlation. Historical observations going back decades further support this data.
Data Courtesy Bloomberg
Given the recent and longer-term correlation, it is sensible to assume that expectations for future economic growth, or GDP, are a solid proxy for future revenue growth.
The following graph of the long-term trend of GDP provides guidance for future revenue expectations. As we have written all too often, demographics, the increasing debt burden, and declining productivity growth will continue to impose a heavy and growing toll on economic growth. That does not mean there will not be periods of stronger than average growth, but we believe the 30-year trend lower is intact.
Data Courtesy Bloomberg
Revenue is only half of the cash flow story. Net earnings, which is what investors are ultimately paying for, account for all of the expenses required to produce revenue. Net earnings as a percent of revenues, better known as profit margin, is the common metric used to express this.
Aggregate profit margins historically vacillate above and below the historical average, but they have always been mean reverting. To wit, here is the wisdom of an investing legend:
The following graphs provide historical context on profit margins over the last two and seven decades respectively.
Data Courtesy Bloomberg and St. Louis Federal Reserve
In both graphs, the profit margin post-financial crisis is at or near all-time highs and has failed to regress to the mean despite the wisdom of Jeremy Grantham.
While not an extensive list, consider the following chief factors responsible for elevated profit margins:
- Lowest interest rates in recorded history
- Minimal wage growth
- Low input costs
- Unchanged shipping, trucking, and freight costs
Review the following table of major corporate expenses to understand current margins and formulate expectations for future ones. The table compares some key proxies for expenses over the last year versus the prior three years.
Data Courtesy Bloomberg
Two aspects of corporate expenses omitted from the table are taxes and tariffs. Recent tax reform boosted margins and helped more than offset the negative effects of the rise in costs shown above. The consequences of the on-going “trade war” are yet to be seen, but they are likely negative.
Since 1877 there are 1654 monthly measurements of Cyclically Adjusted Price -to- Earnings (CAPE 10). Of these 82, only about 5%, have been the same or greater than current CAPE levels (30.5). Other than a few instances over the last two years and two others which occurred in 1929, the rest occurred during the late 1990’s tech boom. The graph below charts the percentage of time the market has traded at various ranges of CAPE levels.
Data Courtesy Shiller
Valuations are a function of investor sentiment. When sentiment is exuberant, as it has been recently, investors are willing to pay more for a series of cash flows in expectations that revenue and earnings will rise at a heady rate in the future. Conversely, when investors are concerned about future earnings and economic growth, valuations tend to decline.
Looking back, there are many factors that drove investors to pay a higher multiple for cash flows over the last ten years. Consider a few:
Historically Low-interest rates
- Lower discounting rates made the value of future earnings higher.
- Resulted in a push towards higher returning, riskier, longer duration securities like equities and long maturity bonds.
Heavy Monetary Stimulus
- Record low-interest rates and burgeoning central bank holdings of financial assets here and abroad.
Corporate Share Repurchases
- Since 2013, S&P 500 companies have annually bought back 3% of their outstanding shares in aggregate.
- Since 2012, net credit balances have been larger than those seen before the market drawdowns of 2000 and 2008.
- Currently, balances are 3x larger than any peak seen in at least the last 36 years.
The proliferation of passive investment strategies which tend to ignore valuations
The expansion of corporate leverage to record highs nominally and as a percent of GDP
To that list we submit one important factor – inflation. The following graph demonstrates that valuations have only been well above the norm during periods when annual inflation is running between one and four percent. Outside of the “sweet spot,” CAPE valuations tend to peak about 25-30% lower than current levels.
Data Courtesy Shiller
How The Market Got Here
With an understanding of the factors that account for price performance since 2010, we now turn to the graphs below which decompose the gains of the last eight years into the components: revenue growth, profit margin expansion, and valuation expansion.
As shown, durable organic growth only accounted for 26.96% of the gains in the S&P 500 index since 2010. In other words, without multiple and margin expansion, the S&P 500 would stand at 1587, a far cry from the current 2790.
DIY- Forecasting the S&P 500
Now we let you forecast where the S&P 500 might be headed over the next five years based on your expectations for revenue, profit margins, and valuations. To formulate a personalized forecast, you will need to complete a two-step process. First, answer the three questions below. Next, feed your answers into one of three tables provided below. The result will be your forecast. To help with answering questions two and three below, we provide current levels along with minimum, average, and maximum historical levels. We also urge you to go back and consider the graphs and factors that drove recent trends.
- How much will GDP, and therefore corporate revenues grow over the next five years?
- Will margins stay at current levels, expand further or contract back to or below historical norms?
- Will valuations stay at current levels, expand further or contract back to or below historical norms?
Once the questions are answered, the data can be used to generate a forecast. The example below offers a guide to the process. In the example shown, the question responses are that GDP growth will average 1% a year for the next five years, and that profit margins and valuations will stay the same for five years. The resulting output of 2838, as highlighted, is the expected value of the S&P 500 in five years.
Choosing among the three tables below is based on your forecast for future economic growth: low 1%, average 3% or high 5%. Once you select the appropriate table, find your expected profit margin for five years from now on the horizontal axis at the top and your estimate for CAPE valuations on the vertical axis on the left. The estimate for the future level of the S&P 500 lies at the intersection of the two forecasts.
The framework described above can be used for something as simple as finding one answer as we did in the example, but it also allows an investor to conduct scenario analysis to arrive at a range of possibilities. By assigning various probabilities to one, two or all variables, one can calculate a weighted average outcome. For example, hold CAPE and Profit Margin constant and assign a 30% probability to 1% GDP growth, 60% probability to 3% growth and 10% probability to 5% growth. Repeating that process produces a range of answers which could effectively be used to gauge risk versus return.
Although relatively simple in its construction, the ability to customize your forecast and apply multiple scenarios is a powerful risk management tool.
Michael Lebowitz, CFA is an Investment Analyst and Portfolio Manager for RIA Advisors. specializing in macroeconomic research, valuations, asset allocation, and risk management. RIA Contributing Editor and Research Director. CFA is an Investment Analyst and Portfolio Manager; Co-founder of 720 Global Research.