In the modern market, such skepticism is reserved only for those companies that are perceived as particularly risky. For example, a $100 investment today in Altria (formerly Phillip Morris) yields $5.50 in dividends.11 An investor earns more today from Altria dividends than from the interest on a 10-year Treasury bond. Because investors fear that smoking-related lawsuits might bankrupt Altria, they price the stock so that they are paid to take risk. While this skepticism exists for Altria, for the market as a whole, investors are willing to accept lower dividends.
Currently, optimistic investors accept low dividend yields in the hopes of future gains. Even without any change in stock market fundamentals, any move that clamps down the bezzle and general optimism would be reflected in lower stock prices.
Where do we stand on stock valuations? Based on the Fed model that compares stocks to 10-year Treasury bonds, stocks appear to be reasonably valued. Based purely on the Fed model, optimists can buy in the hopes of strong profit growth and pessimists can sell on the expectation of profit disappointments and interest rate rises. Beyond the Fed model, however, valuations are dependent on growth rates and emotional swings.
Natural Limits to Earnings Growth
Some years ago, I watched Arnold Schwarzenegger being interviewed about the appeal of bodybuilding. He was asked, why are some people obsessed with physical size? Arnold replied, “You don’t go to the zoo to see the mice.” His claim was that humans are naturally built to care about size. (In Pumping Iron, Arnold seeks to make his opponent Lou Ferrigno feel bad about himself. Accordingly, he hits Lou with the worst insult possible to a bodybuilder, “Lou, you’re looking very small today.”)
Stock market pundits are obsessed not only with the size of corporate profits, but also with their growth rate. You can imagine investors in fast-growing companies making Arnold-like comments of “You don’t buy stocks for their book value.” The obsession with growth is appropriate given the fact that stocks are risky and pay less today than safe Treasury bonds. The main reason to accept the risk of stock market losses is the promise of a growing profit stream. Thus, investors are correctly obsessed with growth.
What are the prospects for corporate profits growth? Here, there is a clear answer. It is that profit growth, and consequently stock prices, cannot continue their historical performance.
Before getting to the reasoning for the limits on profit growth, it is nice to point out that this is one of the few questions that have an unambiguous answer within the investing world. This rarity of clarity is the subject of an entire subset of the jokes about economics (also known as the “dismal science”). For example, if you laid all the economists in the world end to end, they still wouldn’t reach a conclusion. Or, more cruelly, if you laid all the economists in the world end to end, that would be a good thing. To counter this, let’s make the clear statement and then explain the reasoning.
Fact: Corporate profits have been growing above their natural speed limit for a long time. The future for stocks cannot be as bright as the past.
On the road to this conclusion we start at the basics—with bacteria. Almost every biology textbook contains a section that describes bacterial growth rates in terms of something like this: Some bacteria can divide every two hours. If this replication pace were sustained for several weeks, the offspring of one bacterium would weigh more than the universe.
Continuing our Arnold theme, bacteria could mock Internet companies by saying, “Yahoo!, you’re growing very slowly today.” Left unconstrained, one bacterium would become 4,096 in one day, over 16 million in two days, over 60 billion in 3 days, and enough to weigh more than the earth in a couple of weeks.
So bacteria can grow really fast. Over the long run, what has been the growth rate of bacteria? The surprising answer: zero. Bacteria have been around for a really long time. Doing the simple mathematical calculation of the annual growth rate over their history, bacterial growth rates are infinitesimally greater than zero.
An unavoidable mathematical law causes the contrast between doubling every two hours and a long-term growth rate of zero. At least for the last several billion years, the earth itself has not changed significantly in weight. The long-run rate of growth of the earth has therefore been zero. Thus, anything that is a subset of the earth, including bacteria, must have a long-run growth rate of no more than zero.
This is a mathematical truism. A part of a system cannot sustain a higher growth rate than the system for an indefinite time.
Just as bacteria are part of the earth, any single company is part of the global economy. Thus, over the long run, no company can grow faster than the world’s economy. For example, Figure 8.5 shows the growth in Microsoft’s revenues from its public début until today as compared with the growth of the U.S. economy. (The best graph would use global economy growth; the chart uses the United States because the story is the same and the U.S. statistics are more reliable.)
FIGURE 8.5 Microsoft’s Growth Rate Has Slowed toward That of the U.S. Economy
Sources: Microsoft, U.S. Department of Commerce, Congressional Budget Office
When Microsoft was a young company, its growth rate was spectacular. Over the years, however, that growth rate has slowed and now is much closer to that of the entire country. Over the long run Microsoft cannot grow faster than the economy. In fact, the gap is projected to disappear in 2005 (Figure 8.5).12
Whenever a company, or a set of companies, is growing faster than the economy, that growth rate is unsustainable. The relevant question is not if growth will slow to the natural speed limit but when growth will slow.
Both corporate revenue and profits are subject to the same natural speed limit. Neither revenue nor profits can grow faster than the economy indefinitely. Figure 8.6 shows, however, that U.S. corporate profits have been growing faster than the economy.
Looking at the data from the same period as the Microsoft chart, U.S. corporate profits grew faster than the economy. This growth in profits—that is above the natural speed limit—is unsustainable. While there is no obvious time for this above-average growth to end, it must eventually end. The logic is as inescapable as death and taxes.
FIGURE 8.6 Profits Have Grown More Than the Economy
Sources: Bureau of Economic Analysis, U.S. Dept. of Commerce, Congressional Budget Office
Buying the Hype at Precisely the Wrong Time
Profits of U.S. firms have been growing faster than the economy. What does this imply for stock prices? When something is doing better than average, it probably pays to be a bit cautious. If an athlete, for example, has a fantastic year, it would be prudent to expect the next year to be less fantastic.
As investors, it seems that we are built to feel exactly the opposite. We tend to overweight recent events. This leads us to be most optimistic at exactly the wrong time. Consider the case of Sun Microsystems. In the late 1990s Sun was riding a boom caused by Y2K and the Internet bubble. Sun’s revenues and profits were shooting up at rates approaching 100% a year.13
What should a rational investor have done when evaluating Sun’s performance in the late 1990s? The answer is that, rationally, 100% growth rates are unsustainable. Thus, a prudent investor would have given a lower weight to Sun’s current performance. Historically, investors have priced stocks at somewhere between 10 and 20 times a firm’s current profits. Prudence in the late 1990s might have argued that Sun deserved something toward the low end of this range.
Did investors realize that Sun’s performance in the late 1990s was unsustainable? Quite to the contrary, their lizard brains caused them to bid Sun’s price stock up until they were paying close to 100 times current earnings! Precisely at the moment when Sun’s profits were growing at the most unsustainable pace, investors valued those profits at the highest level. The result was financial devastation for Sun shareholders as the stock lost more than 90% of its value.14
Figure 8.7 suggests a potential problem for stock prices. It shows that stock prices have risen even more than
corporate profits in the years since 1987.
The diagram takes the most conservative estimate of stock market appreciation. As a starting point, it takes the highest level of the Dow Jones Industrial Average before the 1987 crash.15 Any other starting point would yield an even higher growth rate. Furthermore, the calculation ignores dividends, which would again serve to dramatically increase stock market returns.
We end up with two layers of unsustainable growth. Corporate profits are growing at an unsustainable pace relative to the economy, and the stock market’s valuation of those profits is growing even faster. If profit growth is going to slow toward its natural limit, then current profits might be reasonably valued at prudent multiples. Quite to the contrary, investors have bid up stock prices so that they are paying more now for every dollar of profits than before.
When will corporate profits and stock prices slow down to their natural speed limit? I was pondering this one night while watching a Tonight Show visit by Phil McGraw (“Dr. Phil”), who was promoting his book The Ultimate Weight Solution. Jay Leno was making fun of the author’s weight, and Dr. Phil responded by saying, “Are you saying I’m too fat to write a diet book?”
FIGURE 8.7 Stock Prices Have Risen Even More Than Profits
Sources: Bureau of Economic Analysis, U.S. Dept. of Commerce, Congressional Budget Office
Leno responded by saying that he wouldn’t be making the joke except that the title of the book is the “ultimate” weight loss solution. Less extreme adjectives, Leno suggested, would have been more appropriate for a man of Dr. Phil’s size. Presumably, “a pretty good weight loss solution” or “moderate weight loss for fatties” would not have drawn Leno’s wit.
Professor Siegel does not make a similar mistake in his work promoting stocks. His book is called the Stocks for the Long Run, not “Stocks for the Super, Super Long Run” or “Jurassic Investing Secrets.” Over the truly long run, Professor Siegel’s argument cannot be right. Stocks cannot be the ultimate investment because over the long run, they can only be average.
No one knows when the natural speed limit will hit corporate profits and stock prices. John Maynard Keynes famously quipped, “In the long run we are all dead.” His point is that arguments about the truly long run have little meaning to people whose horizons stretch out just a few years. Just as Microsoft grew very rapidly for more than a decade, there is no reason to expect an imminent slowdown in the growth of stock prices. Nevertheless, such a slowdown is inevitable.
Buying Stocks with the Wall Street Bulls
Our fundamental analysis so far has made two conclusions. With current profit projections and interest rates, stock prices look to be close to fairly valued. There is some hint of trouble in the fact that both profits and the valuation of the profits are increasing at unsustainable rates. The next piece of the valuation puzzle is an attempt to gauge investors’ moods. The universal investing rule is that popular investments are unprofitable and vice versa. Where do we stand in the cycle of excessive optimism and pessimism toward stock ownership?
We can look at Wall Street gurus for clues. The big financial firms employ market strategists who make both predictions and investment recommendations. Richard Bernstein is one such strategist who works for Merrill Lynch & Co. In 2003, Mr. Bernstein was criticized for being too negative on stocks.16 Bernstein fretted about a number of problems including the U.S. trade deficit and the possibility of rising interest rates.
Compared to his brethren, Mr. Bernstein has been quite negative on U.S. stocks for years. In 2003, however, stocks prices soared. Investors who listened to Mr. Bernstein made less money than if they had listened to his competitors. Not surprisingly, Mr. Bernstein was under fire for his ursine outlook.
How bearish was Mr. Bernstein? The amazing fact is that, for all his “bearishness,” Mr. Bernstein suggested that people invest almost half their total financial wealth in the risky stock market. How can this be considered too bearish? The answer is that we live in an investing climate dominated by Professor Siegel’s view that stocks are the best investment, so almost any portion not in stocks is viewed as “bearish.”
Putting almost half your money at risk seems to be quite a bold suggestion. Nevertheless, Mr. Bernstein was conservative compared to his peers. Table 8.3 shows the recommendations of a set of leading Wall Street firms highlighted by the Dow Jones Newswires at the time that Mr. Bernstein was under fire for being bearish.
This is not a list of the Wall Street bulls; this was the entire list selected by the Dow Jones Newswires! It shows that Mr. Bernstein was more pessimistic about stocks than all of his peers on this list.
This suggests that there is more pain ahead for stocks. While Mr. Bernstein has been getting less flack of late, Wall Street is still extremely bullish on stocks. Investments are profitable when they are hated. Recall that 1982 was the best time to buy U.S. stocks in a lifetime. At that point, stocks were universally hated and essentially ignored.
TABLE 8.3 In an Optimistic Environment, Caution Is Labeled Pessimistic
Source: Dow Jones Newswires17
Reasons to Own Stocks Even If They Are Only Average Investments
When I was a teenager, I spent some time at the local roller skating rink. In addition to enjoying the huge bell-bottoms and other clothes from the 1970s (the decade that taste forgot), I was puzzled by one of the establishment’s rules. As an unskilled but thrill-seeking skater, I was constantly getting in trouble with the staff for skating too fast.
While I am sure that I did skate too fast, the rules made no sense. “No skating faster than average” was the law posted around the skating club. I spent many hours grappling with the logic. If even one person skates slower than the average, then by pure mathematics, someone else (and maybe many people) must be skating faster than the average. So the rule made no sense. The skating rink’s employees were unimpressed with my logic, but I learned the mathematics of averages.
When it comes to investments, the logic of averages is unavoidable. No investment class can be above average indefinitely. Stocks have had a long run and are not cheap. So I don’t recommend buying stocks in the hopes that they will have higher returns than other assets.
Even if stocks are only average, however, there are some good reasons to buy them. First, stocks provide protection against inflation and deflation. By buying stocks, and therefore the real assets that they represent, you are locking in purchases at today’s prices. This means that if inflation rates rise, the value of those underlying assets should also rise. Similarly, if prices fall, the assets controlled by the corporation will also fall. So stocks provide protection in the event that the United States’ long run of almost perfect inflation rates ends.
Second, stocks provide protection against currency swings. Because many U.S. companies derive substantial revenue from international sales, stock prices are buffered against changes in the value of the dollar. In 2003, for example, the U.S. dollar lost about 20% of its value against the euro, and lost substantial ground against most other currencies.18
The decline of the dollar made most Americans poorer. When we go to buy a bottle of French wine or a car made in Japan, our dollars buy less. However, the earnings of many U.S. companies were helped by the decline in the dollar. Continuing our Microsoft theme, a piece of software that sold for 100 euros brought in over 120 dollars at the end of 2003 versus about 100 dollars at the start of the year. By selling the exact same product at the exact same price in foreign currency Microsoft reaped higher returns.
Stocks can be bought for risk-reducing reasons even if they are going to be only average investments. This is an interesting turn of events. Stocks are often thought of as the high-risk, potentially high-reward investments. It may be that stocks have become average investments with some risk-lowering features.
Another reason to buy stocks is the ability to avoid taxes legally. Both capital gains and dividends are subject to low tax rates. In addition, it is possible to build your own tax-advantag
ed mutual fund. The technique is to own a lot of stocks and to make sure that before the year ends, you sell enough of the losers so that your tax bill is zero. This feature of stocks has always existed, but until recently it was not feasible for most people because of high trading commissions. The online brokerage revolution has made it possible to legally defer paying taxes on stock market gains indefinitely.
Just as a family loves all its children, even the ones who are not superstars, there are good reasons to own stocks even if they are going to be only average investments.
Mean Markets and Lizard Brains Page 20