Sep 25th 2018

Do Spectacular Earnings Justify Spectacular US Stock Prices?

 

NEW HAVEN – The US stock market, as measured by the monthly real (inflation-adjusted) S&P Composite Index, or S&P 500, has increased 3.3-fold since its bottom in March 2009. This makes the US stock market the most expensive in the world, according to the cyclically adjusted price-to-earnings (CAPE) ratio that I have long advocated. Is the price increase justified, or are we witnessing a bubble?

One might think the increase is justified, given that real quarterly S&P 500 reported earnings per share rose 3.8-fold over essentially the same period, from the first quarter of 2009 to the second quarter of 2018. In fact, the price increase was a little less than equal to earnings.

Of course, 2008 was an unusual year. What if we measure earnings growth not from 2008, but from the beginning of the Trump administration, in January 2017?

Over that 20-month interval, real monthly US stock prices rose 24%. From the first quarter of 2017 to the second quarter of 2018, real earnings increased almost as much, by 20%.

With prices and earnings moving together on a nearly one-for-one basis, one might conclude that the US stock market is behaving sensibly, simply reflecting the US economy’s growing strength.

But it is important to bear in mind that earnings are highly volatile. Sudden sharp increases tend to be reversed within a few years. This has happened dramatically more than a dozen times in the US stock market’s history.

Earnings are different from most other economic variables, because they are defined essentially as the difference between two series: revenues and expenses. Rapid growth in earnings for a few years can thus easily be followed by a return to the long-term trend or even subpar levels. In fact, S&P 500 reported earnings per share were negative during the fourth quarter of 2008, partly owing to financial-crisis-induced write-offs. Of course, that episode didn’t last (and its significance has been questioned).

Market participants ought to know that they shouldn’t overreact to earnings growth, but they sometimes forget if popular narratives mislead. Consider an example from a century ago. Although real S&P Composite annual earnings rose 2.6-fold in just two years, from around trend in 1914 to a record high in 1916, stock prices rose only 16% from December 1914 to December 1916. Why didn’t the market respond as it has recently?

From newspaper reports at the time, one can glean some clues. Most important, people attributed the increase to sudden panicky demand for US goods from Europeans and others at the beginning of World War I. When the war ended, then, profits would return to normal. Moreover, widespread anger over high war profits while men were being conscripted to risk their lives led many people, not just Americans, to start advocating for “wealth conscription.” This forgotten term, which dropped out of usage following World War II, referred to heavy taxation on sudden increases in profits. Indeed, the US first imposed a punitive tax on corporate profits above prewar levels when it entered the war in April 1917.

But stock price movements haven’t always been as rational as they were in 1916. Market reaction to earnings increases was much more positive in the “roaring twenties.” After the end of the 1920-21 recession, real annual earnings, which had been depressed by the downturn, increased more than fivefold in the eight years to 1929, and real stock prices increased almost as much – more than fourfold.

What was different about the 1920s was the narrative. It wasn’t a foreign war story. It was a story of emergence from a “war to end all wars” that was safely in the past. It was a story of the liberating spirit of freedom and individualistic fulfillment. Unfortunately, that spirit did not end well, with both stock prices and corporate earnings crashing catastrophically at the end of the decade.

There was then a period, from 1982 to 2000, when real stock prices increased 7.5-fold while real annual earnings only doubled. The end of this period has been called the dot-com boom or Internet boom, but most of the price growth preceded the tech-driven “new economy” narrative, and declining inflation helped throughout. By 2003, however, both real earnings and real stock prices fell by almost half.

Then, from 2003 to 2007, during a period of gradual recovery following the 2001 recession, real corporate earnings per share almost tripled. But the real S&P 500 less than doubled, because investors apparently were unwilling to repeat their mistake in the years leading to 2000, when they overreacted to rapid earnings growth. Nonetheless, this period ended with the financial crisis and another collapse in earnings and stock prices.

That brings us to the current boom in earnings and prices. Apparently, investors believe that this boom is going to last, or at least that other investors think it should last, which is why they are bidding up stock prices in a dramatic response to the earnings increase.

The reason for this confidence is hard to pin down, but it must be rooted in the public’s loss of healthy skepticism about corporate earnings, together with an absence of popular narratives that tie the increase in earnings to transient factors. Talk of an expanding trade war and other possible actions by a volatile US president just does not seem strongly linked to talk of earnings forecasts – at least not yet.

A bear market could come without warning or apparent reason, or with the next recession, which would negatively affect corporate earnings. That outcome is hardly assured, but it would fit with a historical pattern of overreaction to earnings changes.


Robert J. Shiller, a 2013 Nobel laureate in economics and Professor of Economics at Yale University, is co-author, with George Akerlof, of Phishing for Phools: The Economics of Manipulation and Deception. 

Copyright: Project Syndicate, 2018.
www.project-syndicate.org

 


This article is brought to you by Project Syndicate that is a not for profit organization.

Project Syndicate brings original, engaging, and thought-provoking commentaries by esteemed leaders and thinkers from around the world to readers everywhere. By offering incisive perspectives on our changing world from those who are shaping its economics, politics, science, and culture, Project Syndicate has created an unrivalled venue for informed public debate. Please see: www.project-syndicate.org.

Should you want to support Project Syndicate you can do it by using the PayPal icon below. Your donation is paid to Project Syndicate in full after PayPal has deducted its transaction fee. Facts & Arts neither receives information about your donation nor a commission.

 

 

Browse articles by author

More Current Affairs

Oct 14th 2018
Now the Trump administration is eroding the dollar’s global role. Having unilaterally reimposed sanctions on Iran, it is threatening to penalize companies doing business with the Islamic Republic by denying them access to US banks. The threat is serious because US banks are the main source of dollars used in cross-border transactions. According to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), dollars are used in nearly half of all cross-border payments, a share far greater than the weight of the US in the world economy. In response to the Trump administration’s stance, Germany, France, and Britain, together with Russia and China, have announced plans to circumvent the dollar, US banks, and US government scrutiny. “Plans” may be a bit strong, given that few details have been provided. But the three countries have described in general terms the creation of a stand-alone financial entity, owned and organized by the governments in question, to facilitate transactions between Iran and foreign companies.
Oct 5th 2018
There are a lot of oddballs in US President Donald Trump’s entourage, but few are as odd – or as sinister – as 33-year-old Stephen Miller, Trump’s senior policy adviser. Miller resembles a type on the far right that is more common in Europe than the US: young, slick, sharp-suited, even a trifle dandyish. He is a skilled rabble-rouser, whose inflammatory rhetoric against immigrants and refugees – “We’re going to build that wall high and we’re going to build it tall !”– drives the crowds at Trump rallies into a frenzy. One of his crowd-pleasing notions is that migrants will infect Americans with terrible diseases.
Oct 3rd 2018
.....here we are in 2018, 40 years after Camp David. The Palestinian dream of an independent state is not only unrealized but is most likely unrealizable. With many Palestinians now favoring a one state solution......the once "Arab minority"  is now a majority.....
Sep 25th 2018
The US stock market, as measured by the monthly real (inflation-adjusted) S&P Composite Index, or S&P 500, has increased 3.3-fold since its bottom in March 2009. This makes the US stock market the most expensive in the world, according to the cyclically adjusted price-to-earnings (CAPE) ratio that I have long advocated. Is the price increase justified, or are we witnessing a bubble?
Sep 23rd 2018
Global debt recently hit a new record high of 225% of world GDP, amounting to US$164 trillion. The world is now 12 points deeper in debt than the previous peak in 2009, with advanced economies’ ratios at levels not seen since World War II.
Sep 18th 2018
To understand them, it is worth looking at three reputable leaders who died this summer: former United Nations Secretary-General Kofi Annan, former British Foreign Secretary and NATO Secretary-General Peter Carrington, and US Senator John McCain. Having worked with Annan and for Carrington, I can vouch for their grace, honor, and commitment to truth. McCain plainly had the same qualities, not to mention a level of personal bravery far beyond what is expected of most of us (though it should be noted that Carrington was also a war hero). These leaders’ combination of honor and commitment to truth – two attributes that are intrinsically connected – is nowhere to be seen in Trump or Johnson.
Sep 18th 2018
From controlling the media to stoking nationalism, Russian President Vladimir Putin has always known how to keep his approval ratings high. But Russians’ lives are not getting any better, especially after the latest round of Western economic sanctions – and Putin’s declining approval rating shows it.
Sep 15th 2018
As we mark the decennial of the collapse of Lehman Brothers, there are still ongoing debates about the causes and consequences of the financial crisis, and whether the lessons needed to prepare for the next one have been absorbed. But looking ahead, the more relevant question is what actually will trigger the next global recession and crisis, and when. The current global expansion will likely continue into next year, given that the US is running large fiscal deficits, China is pursuing loose fiscal and credit policies, and Europe remains on a recovery path. But by 2020, the conditions will be ripe for a financial crisis, followed by a global recession. There are 10 reasons for this. First, the fiscal-stimulus policies that are currently pushing the annual US growth rate above its 2% potential are unsustainable. By 2020, the stimulus will run out, and a modest fiscal drag will pull growth from 3% to slightly below 2%.
Sep 12th 2018
Next month, a judge in Oregon will begin hearing a case brought against the United States government on behalf of 21 young people, supported by the non-profit organization Our Children’s Trust, who allege that the authorities’ active contributions to the climate crisis violate their constitutional rights. The government defendants have repeatedly tried – so far without success – to have the case thrown out or delayed, and the trial is currently scheduled to start on October 29.
Sep 5th 2018
Wars are expensive, as the Russian people are now learning. The Kremlin is pursuing military adventures in Eastern Ukraine and Syria, and though these conflicts are limited in scope, one wonders if the country can really afford them.
Sep 1st 2018
This week, the California state legislature voted to mandate that all the state’s electricity come from non-carbon sources (chiefly wind, solar and hydro) by 2045. Since California if it were a country would have the world’s fifth largest economy, and since so many other states are economically integrated with it, this plan, if signed by governor Jerry Brown, could help transform the entire country. The goal is less difficult than it seems on the surface. California had already committed to getting one third of its electricity from renewables by 2020, and reached that goal in 2017. It committed to getting 50% of its electricity from renewables by 2030, and in fact will likely reach that goal 10 years early, in 2020.
Aug 29th 2018
Quote: "This may ultimately result in creation of a new accounting standard - the Enterprise Value of Data – which could become an integral part of financial statements, capturing the value of the largest and most ignored corporate asset: data."
Aug 29th 2018
What comes through clearly in polling on US public opinion is that there is a deep partisan divide on the Israeli/Palestinian issue, with key demographic groups increasingly more supportive of Palestinian rights and antagonistic to hardline Israeli policies. In some ways, the Netanyahu/Trump "marriage" has also helped to fuel the partisan divide. A Pew poll from earlier this year found that support for Palestinians far surpasses support for Israel among self-described "progressive" and "liberal" voters. And a recent Gallup poll shows that only 17% of Democrats now have a favorable view of the Israeli leader. 
Aug 27th 2018
History suggests that current-account imbalances ultimately matter a great deal. A still-unbalanced global economy may be forced to relearn that painful lesson in the coming years.
Aug 27th 2018
The United States economy is doing well. But the next recession – and there is always another recession – could be very bad. The US Bureau of Economic Analysis estimates that GDP growth in the second quarter of 2018 reached 4.1% – the highest since the 4.9% seen under President Barack Obama in 2014. Another year of growth will match the record ten-year expansion of the 1990s. Add to that low unemployment, and things are looking good. But this cannot continue forever.
Aug 24th 2018
If Britain leaves the European Union with no deal in place to govern trade with its biggest partner, it will fall back on World Trade Organisation rules. The same set of rules would apply to EU countries and non-EU trade partners. This is why the UK government has published a series of “technical notices” detailing preparations for a no-deal Brexit. Here are seven reasons that sum up why a no-deal Brexit and defaulting to WTO rules would be bad for British businesses and the wider economy.
Aug 23rd 2018
Unlike today’s aspiring strongmen, a truly tough leader would stand up for international cooperation, and seek to persuade voters why it matters. One hopes that French President Emmanuel Macron, German Chancellor Angela Merkel, and Japanese Prime Minister Shinzo Abe will do precisely that in the coming months. In the meantime, we must pray that wannabe tough guys like Trump and Erdoğan do not do too much damage to their respective countries, and to the rest of us. It is time to make cooperation great again.
Aug 23rd 2018
Historians will mark August 21, 2018, as a turning point in American history. President Donald Trump’s personal lawyer pleaded guilty to 8 counts of criminal wrongdoing that could carry a sentence of up to 65 years. Most significantly, he pleaded guilty to having attempted illegally to interfere in an election “in coordination with and at the direction of a federal candidate for office.”
Aug 22nd 2018
As the usual political inferno between parties and private firms rages on, the phantom threat of mafia involvement in Italian construction has resurfaced. The region of Liguria sadly scores quite high in the assessments of mafia infiltration. In the area, Calabrian mafia clans of the ‘ndrangheta – Italy’s most powerful mafia today – have heavily invested in the construction sector, in public tenders and in the exploitation of the port of Genoa and the roads to France and to the rest of the Italian north, for the purposes of illegal trafficking.
Aug 15th 2018
Why do conspiracy theories and general charlatanism so often receive their strongest support from the world’s dictators? Sure, dictators are almost always oddballs themselves, but that cannot be all there is to it. In fact, it is worth asking whether quackery is a necessary feature of authoritarian rule.