Ewherever you are Look, the stock markets are breaking records. U.S. stocks, as measured by the S&P 500 index, which hit their first all-time high in more than two years in January, soared above 5,000 points in February and roared well above that level on February 22 as Nvidia, a maker of hardware essential for artificial intelligence (AI), produced spectacular results. Same day, Europe STOXX 600 set its own record. Even before Nvidia’s results were announced, Japan’s Nikkei 225 had surpassed its previous record set in 1989. It’s no surprise that a widely watched global stock index also recently hit a record high (see Chart 1).
This is quite a turnaround. Stocks tumbled in 2022 as they faced rapidly rising interest rates and faltered last March amid a banking panic. Now, however, both episodes look like brief interruptions in the long march of stock prices. Despite mediocre economic growth and the Covid-19 pandemic, stock markets have offered annual returns, after inflation, of more than 8% per year since 2010, including dividends (cash payments to shareholders, funded by corporate profits) and capital gains (when the price increases). of a share increases). These returns were better than those of bonds and houses. In fact, they have been better than those of virtually every other asset class.
If the boom has a home, it’s America. One hundred dollars invested in the S&P 500 on January 1, 2010 is now worth $600 (or $430 at 2010 prices). However you measure them, U.S. returns have surpassed those elsewhere. Nearly 60% of Americans now report owning stocks, the most since reliable data began to be collected in the late 1980s. Many of them, but also many professional investors, have a question. Is the rise in the stock market sustainable or the prelude to a correction?
For as long as stock markets have existed, there have been people predicting an impending crash. But today, in addition to the usual ominous pronouncements, a chorus of academics and market researchers argue that it will be difficult for American companies to deliver what is needed over the long term to reproduce the extraordinary stock market returns of recent years. The Federal Reserve’s Michael Smolyansky has written about the “end of an era” and warned of “significantly lower earnings growth and stock returns in the future.” Goldman Sachs, a bank, has suggested that the “tailwind of the past thirty years is unlikely to provide much support in the coming years.” Jordan Brooks from AQR Capital Management, a quantitative hedge fund, has concluded that “a repeat of the stock market performance of the past decade would require a heroic set of assumptions.”
That’s partly because valuations are already at eye-popping levels. Its most widely followed measure was devised by Robert Shiller of Yale University. It compares prices to inflation-adjusted profits over the past ten years – a period long enough to smooth out the economic cycle. The result cyclically adjusted price-earnings ratio, or CAPE, has never exceeded 44.2, a record set in 1999, during the dot-com bubble. The previous peak was in 1929, when the CAPE tap 31.5. This now stands at 34.3 (see graph 2).
Rarely have corporate profits been valued so highly. And the outlook for the profits themselves is also challenging. To understand why, we need to consider the fundamental sources of their recent growth. We used Mr. Smolyansky’s methodology to examine U.S. companies’ national accounts data. Between 1962 and 1989, net profits increased by 2% per year in real terms. Then gains accelerated. Between 1989 and 2019 they increased by more than 4% per year. We see similar trends all over the world OECDa club of mostly rich countries. As a share of GDPCorporate profits were stable from the 1970s to the 1990s, after which they doubled (see Chart 3).
Mirror market
Yet much of this strong performance is in some ways a mirage. Politicians have lowered the tax burden on corporations: from 1989 to 2019, the effective corporate tax rate for U.S. companies fell by three-fifths. As companies gave less money to the state, corporate profits rose, leaving them with more money to pass on to shareholders. Meanwhile, borrowing became cheaper over the same period. From 1989 to 2019, the average interest rate for US companies fell by two-thirds.
Following Mr. Smolyansky, we see that in America the difference in earnings growth during the period 1962-1989 and the period 1989-2019 is “entirely due to the decline in interest rates and corporate tax rates.” If we extend this analysis to the rich world as a whole, we find similar trends. The increase in net profits is actually the result of lower taxes and interest charges. Underlying earnings measures have grown less impressively.
Now companies are facing a serious problem. The decades-long decline in interest rates has been reversed. Risk-free interest rates in the rich world are about twice as high as in 2019. There is no guarantee they will return to these lows – let alone fall quite steadily, as was the case in the decades before the pandemic .
On taxes, the political winds have changed. It is true that Donald Trump may see fit to cut US corporate taxes if he wins in November. But our analysis of 142 countries shows that in 2022 and 2023 the average statutory corporate tax rate rose for the first time in decades. For example, in 2023, Britain increased its main corporate tax rate from 19% to 25%. Governments have also set a global minimum effective corporate tax rate of 15% for large multinational corporations. Once this is established, such companies are likely to pay between 6.5% and 8.1% more in tax, leaving a smaller net profit.
So what needs to happen for US stocks to continue delivering exceptional returns? One possibility is that investors are paying for even more stretched valuations. In a world where interest rates and tax bills remain constant over the next decade while real profits grow at 6% per year – an optimistic scenario – America will CAPE would have to increase to 51 to reproduce the total return from 2013 to 2023. That would be higher than ever before.
Now make things even grimmer and assume valuations return to where they are. The CAPE drifting towards 27, close to the average since the end of the dotcom bubble. Also suppose that interest rates and tax bills increase. Instead of clocking in at 25% of profits, they are rising to 35%, or around the level in the first half of the 2010s. In this more realistic world, real profits would have to grow at 9% per year to even generate half the returns that equity investors have enjoyed since 2010. According to Brooks, America has achieved this kind of growth only twice in the post-war period, and in both cases the economy recovered from a crisis – once after the dot-com bubble and once after the global financial crisis of 2007-2009.
Many investors hope so ah will ride to the rescue. Surveys of CEOs show great enthusiasm for tools that rely on technology. Some companies are already deploying them, claiming they deliver transformative productivity gains. If the tools are deployed more broadly, companies can reduce costs and produce more value, boosting economic growth and corporate profits.
Keep it stupid
Needless to say, this is a heavy burden for a technology that is still in its infancy. Moreover, technological developments are by no means the only trend that will influence business in the coming years. Companies face an uncertain geopolitical environment, with global trade flat or even declining depending on the metric. In America, both parties are skeptical of big business. The battle against inflation has also not yet been won: interest rates may not fall as far or as quickly as investors expect. Over the past few decades, it would have been foolish to bet against the stock markets, and timing a recession is virtually impossible. But the business world is about to face a huge test. ■