David Kelley: Checking Foundations of a Roaring Bull Market

As I get older, my memory gets a little foggier. That being said, I believe it was at lunch at a restaurant near our office on Friday, March 6th, 2009, when I and the then three other members of the Market Insights Team, Andy, Marlene and Jerry, made a bet. That day, although we didnt know it at the time, the stock market hit its financial crisis low and the bet concerned how long it would take for the market to recover its losses. Being the most optimistic of the four of us at the time, I believe I won that bet. However, I cant be sure since I promptly managed to lose the piece of paper upon which I had recorded our guesses. Ive also forgotten what the stakes were. Id like to think that it was lunch in which case, Marlene, Andy and Jerry I am still waiting. However, given the financial stress of the time, perhaps we only bet a dollar.

One thing I know for sure, however, was the depth of the market decline a whopping 57% from peak to trough. Over the course of that Friday, the SP 500 dipped to a level of 666 a number that added some grim humor to the occasion. I was thinking about this last Friday, when the SP 500 closed at 6,664 almost exactly 10 times as high, 16 years later.
This has been an epic bull market, stretching, with some interruptions, all the way back to the 1980s. The biggest part of market gains have not come from economic growth but rather from a rising profit share of GDP and higher P/E multiples. With all of these trends looking challenged or stretched today, its an important time to assess whether this U.S. equity outperformance can continue and, if not, how to adjust portfolios to guard against weakness in the increasingly lofty scaffolding underpinning this roaring bull market.

Sizing up a Long Bull Market

By convention, a bull market is defined as a gain of at least 20% in stock prices and ends with the advent of a bear market, defined as a decline of the same magnitude. By these yardsticks, there have been multiple bull and bear markets in recent decades.

However, in a broader sense, the U.S. stock market has been in a long bull run since the mid-1980s, because that is when the value of U.S. stocks began to outpace the economy itself, a trend that continues to this day.

Between the third quarter of 1955 and the third quarter of 1985, the value of all U.S. corporate equity averaged 72% of GDP. It then started a remarkable ascent, reaching 212% by the first quarter of the new century, just before the dot-com bubble burst and, we estimate, attaining a record high of 363% last Friday.

Between 3Q55 and 3Q85, the SP 500 provided an annual average total return, including dividends, of 8.8%. In the 40 years since, it has returned an astounding 11.6% per year.

At todays stock market levels, some investors are naturally worried about the danger of a market collapse.

Others are more concerned about the size of prospective gains from here. However, either question requires an assessment of all three aspects of the scaffolding supporting U.S stock prices, namely GDP growth, the profit share of GDP and valuations.

The Outlook for Growth

As noted earlier, soaring stock market returns in recent decades dont reflect stronger economic growth.

Between 3Q55 and 3Q85, nominal GDP growth averaged 8.0%, comprised of a 3.4% real GDP gain and 4.4% inflation. Over the past 40 years, nominal GDP growth has averaged just 5.0% per year, comprised of 2.6% real growth and 2.3% inflation.

Still, starting from here, rising profits would be easier to achieve in a faster-growing economy. So what is the outlook from an economic growth perspective?

We currently estimate that nominal GDP grew by 4.8% in the year ending this quarter and it may advance at a slightly slower pace over the next year, as trade andimmigration policies slow real GDP growth to 1.6% year-over-year but boost GDP deflator inflation to 2.7%. Thereafter, nominal GDP growth should decelerate further, as inflation comes down to 2.0% and real growth settles in at between 1.5% and 2.0%, with AI productivity gains not quite offsetting the negative impact of close-to-zero labor force growth. Barring a shock, the U.S. economy should be able to avoid outright recession. That being said, the sluggish growth outlook is not particularly supportive for profits.

The Outlook for the Profit Share of GDP

What about the profit share of GDP? Between 3Q55 and 3Q85, the adjusted after-tax profits of all U.S. corporations averaged 6.2% of GDP. We estimate that, in the third quarter of this year, they will amount to 10.8%, continuing a long and dramatic upward trend.

While there are many factors behind a surging profit share of GDP, three stand out:

• ??First, net interest, which is the net interest income of households less interest paid by the government and so, roughly, reflects the interest paid by companies, has fallen from an average of 4.0% of GDP between 3Q55 and 3Q85 to just
  0.7% of GDP today.
• ??Second, corporate taxes averaged 3.4% of GDP between 3Q55 and 3Q85. We expect them to amount to just 2.3% of GDP in the third quarter.
• Third and most importantly, employee compensation averaged 55.9% of GDP between 3Q55 and 3Q85, but we expect it to be just 51.5% in the third quarter of this year.
• Productivity growth hasnt actually changed much over the past 40 years as compared to the previous 30. We saw a 1.6% average annual increase in output per worker between 3Q55 and 3Q85 and 1.5% since then.

• However, U.S. corporations have proven very adept at gaining a rising share of national income, benefitting from lower interest rates and lower corporate taxes and squeezing compensation costs.

  Going forward, gains in all of these areas may be more challenging. While the Federal Reserve has just embarked on a new round of rate cuts, there should be limited room for long-term Treasury rates to fall, given rising government debt and assuming inflation settles in at roughly 2%. In addition, spreads on corporate bonds are already tight by historical standards and so are unlikely to narrow much from here.

  Effective corporate tax rates have fallen again with the passage of OBBBA and its 100% expensing of RD and equipment purchases. However, the near-term tax break from full expensing will reduce depreciation as a way to lower tax bills going forward. Moreover, U.S. companies are likely to get stuck with at least part ofthe cost of todays much higher tariffs.

On the compensation front, there is little sign of any surge in union activity to get higher wages and benefits.

However, a continuing labor shortage, due to the immigration crackdown, should sustain wage growth going forward.

In short, while we dont expect a near-term collapse in corporate margins, or, more broadly, adjusted after-tax profits as a share of GDP, there is also little reason to expect any further increase in these margins.

The Outlook for Multiples

And then there is the issue of multiples. As of Friday, the SP 500 was selling at 22.6 times forward earnings, roughly 1.7 standard deviations above its 30-year average. However, the last 30 years have generally seen above-average P/E ratios and changing accounting standards make long-run comparisons somewhat challenging using Standard and Poors data.

One alternative is to look at the market cap of all U.S. corporate equity divided by adjusted after-tax profits for the past year. By this measure, the P/E ratio of the entire U.S. equity market is currently 33.1 times lagged earnings, 2.7 standard deviations above its 15.9 average over the past 70 years. However, again, the real liftoff in P/E ratios began in the mid-1980s....this measure of P/Es averaged just 11.3 times between 3Q55 and 3Q85.

So why have P/E ratios risen so much?

Some of the justification could be significantly lower long-term interest rates which should boost the value of all asset prices relative to their associated income streams. Part of the reason could be a long-term decline in dividend and capital gains tax rates that have boosted the prospective after-tax value of equity returns. More stable growth in real GDP and profits, combined with more diversified long-run portfolios, may have reduced the risk, or at least the perceived risk, in holding stocks.

However, at least part of the reason could simply be embedded capital gains. The longer a bull market continues, the greater is the capital gains hit to any investor in a taxable account who wishes to cash in their gains to rebalance their portfolio - a particularly unattractive proposition since tax law allows for a resetting of the basis for capital gains when their wealth is passed on to their heirs. The vast majority of stock market wealth is held by the richest Americans and, while they have every incentive, given past performance, to add to their equity holdings, selling is a financially more painful proposition.

Investment Implications

Given all of this, there is simply no way of knowing how much further P/E multiples could rise or how much they might fall, were they to begin to retreat. However, investors should recognize the potential for a problem.

Some unexpected event, such as a massive cyberattack, a natural disaster or a geopolitical conflict could trigger a recession. Economic populism could eventually result in much higher corporate taxes. Or the growing dysfunction of our political system and the federal finances could lead to a flight out of dollar assets to cheaper alternatives in overseas markets. Or something else could trigger the start of a bear market and, once it got going, a bear market itself would generate unrealized losses, softening the tax blow of selling stocks to conduct long-overdue rebalancing.

We didnt know, early in March of 2009, that we were at the very bottom of a bear market. Nor will we receive an announcement when we finally reach the peak of the current, very-extended bull market. That being the case, it is simply best to be prepared. And being prepared today, given current valuations and prospects, means chipping away, as tax-efficiently as possible, at a U.S. mega-cap equity overweight by diversifying into international stocks, core fixed income and alternative assets.