Stein’s Law, a principle from the late Herbert Stein, Chairman of the Council of Economic Advisers during the Nixon administration, states “If something cannot go on forever, it will stop”.
Mr Stein’s observation was made during the debate over how to address the widening US current account deficit in the 1980s, and his words were a reminder that knowing if and when to act is never easy. The idea seems relevant today in another context, the stock market, which has been booming. After realising an 18% average annualised total return since the low in early March 2009 (i.e., the bottom of the global financial crisis) through to the end of April 2019, investors in the US stock market may ask: will this last?
Consider the three components of those fabulous returns. First, and admittedly the least exciting source, is dividends. Although the dividend yield for the S&P 500 Index briefly rose above 3% at the height of the crisis, during the bull market, the yield quickly fell into a range of 2% to 2.5%. Today it resides closer to 2% on a forward-looking basis. Given the average payout ratio of 35% in the index, dividends appear well covered and are perhaps the most solid building block of an expected forward-looking rate of return.
The second component of returns – growth in earnings per share (EPS) – is where the real action has been. The consensus estimate for EPS for the S&P 500 Index over the next 12 months has soared from $68 in 2009 to $177 in 2019, a rate of 10% per year (as of April 2019). Corporate profits have benefited from several tailwinds, including a growing global economy, capital capturing a greater share of income relative to labour, a reduction in corporate taxes and increasing balance sheet leverage that magnifies results.
However, looking ahead, it is difficult to see these trends continuing at such high rates, if at all. Real global GDP growth (gross domestic product growth adjusted for inflation) is expected to be approximately 3.5% over 2019 and 2020, according to the International Monetary Fund’s latest outlook. China’s workforce is shrinking and wages in the US are rising at the fastest rate since the crisis. The benefit of lower taxes to EPS will normalise soon and, while the use of cheap debt-to-fund share repurchases has lowered the number of shares in circulation, leverage ratios are increasingly stretched, leaving weaker credits in a more vulnerable place. All of this is to say that, while corporate profits may well continue to grow, the rate of growth is likely to slow, perhaps significantly.
EPS and valuation multiples have expanded dramatically for the S&P500
Source: Factset, 4 March 2005 to 30 April 2019. NTM is ‘next 12 months’. EPS is ‘earnings per share’.
But wait; there is more, the third component. It wouldn’t be a proper bull market without significant multiple expansion, and recent experience does not disappoint in that regard. After bottoming at a 10x forward estimated earnings per share (EPS) during the dark days of the financial crisis, the S&P 500 Index is currently trading at 16.7x earnings. This change in valuation multiple – call it the ‘Psychological Swing Factor’ – contributed approximately 5% per year to returns over the past decade (to end of April 2019).
Seasoned investors will know that valuation multiples fluctuate, and while there are good reasons for at least a portion of the increase realised during the bull market (e.g. low interest rates), this component of returns could very well become a headwind in the future should anything go awry. Add it all up – actually multiply 1.025 (2.5% dividends) x 1.10 (10% earnings) x 1.05 (5% valuation) – and you have had a wonderful bull market of 18% per year. But that is in the past and investors always need to look forward: lower starting dividends, mounting EPS headwinds and the possibility of lower valuation multiples suggest a much more modest outlook for returns.
Accepting that the future likely holds the prospect of lower returns than the recent past, what might an investor do? First, we believe investors should maintain valuation discipline. Consider selling or trimming winners where the valuation has expanded to a level that no longer offers a solid risk-adjusted return potential (this may include technology and other “growth” stocks). Second, avoid excessively levered balance sheets. Remember that leverage magnifies outcomes (both good and bad), and reduces staying power in the event of turbulence.
Third, go off the beaten path and maintain high active shares. As the market becomes less attractive, investors should consider being less like the market in their portfolios. Fourth, consider increasing allocations outside the US. The MSCI EAFE Index has lagged the US by 7% per year for the last decade, and some pockets of gloom (Brexit) are excessive, in our view.
Finally, diversify. Our team at Perkins is maintaining its discipline around building what we believe are well-balanced portfolios, comprised of attractive reward-to-risk stocks with a wide variety of underlying drivers of earnings and valuations.
Whether the bull market ends with a bang or a whimper, it will eventually end. Tempting as it may be, this is not really a question of timing. The only time frame that matters for most savers is the long term. As the balance between potential reward and downside risk becomes less attractive, investors would do well to become more defensive in their portfolios.