Home > Uncategorized > Do stockholders look forward to a decade of very low returns?

Do stockholders look forward to a decade of very low returns?

from Dean Baker

In spite of completely missing the crash of the stock bubble in 2000-2002 and the housing bubble in 2007-2010, people tend to think that the big actors in the stock market have great insight into the economy’s prospects. While I won’t claim to have a crystal ball that predicts the future of the economy (I had warned of both of those crashes), I did learn arithmetic in third grade.

There are some simple and important statements we can make about future stock returns, based on nothing more than arithmetic and the generally accepted projections for the economy’s performance. The basic story is that if we accept the projections for future profit growth from the Congressional Budget Office, or other official forecasters, then we are almost certain to see a decade of extraordinarily low returns to stockholders.

Real returns will almost certainly be less than 5.0 percent annually. This compares to a long period average of close to 7.0 percent. And this assumes no plunge in the market over the decade. Of course, if the market does plunge, real returns will be considerably lower.

The reason that returns will almost certainly be low in the next decade is that stock prices are high. If we look at Robert Shiller’s calculations of the price of the S&P 500 relative to ten years of trailing earnings, it was at 31.5 for February to date. That compares to an average of 20.6 in the 1960s, 12.7 in the 1970s, and 11.5 in the 1980s. A high price to earnings ratio means that people buying or holding stock are paying a high price for each dollar of earnings.

To see what this means more concretely, we can take the most recent price to earnings figure from Shiller’s data. Taking February’s prices over December’s earnings, we get a ratio of 23.7. Taking a somewhat broader, but somewhat dated measure, the value of all corporate equities was $49.6 trillion at the end of the third quarter. After-tax corporate profits were $1,869 billion, giving a price to earnings ratio for the market as a whole of 26.5.[1]

The fact that these two figures are close should give us confidence that we are looking at the right numbers. It would not be surprising that the whole market would have a higher PE than the S&P 500. The index is by design composed of older well-established companies. Many smaller and newer companies may have high valuations based on growth prospects rather than current profits.

Anyhow, we can work from the slightly lower PE reported by Shiller for the S&P 500. The ratio of 23.7 implies an earnings-to-price ratio of 4.2 percent. This means that for each dollar a shareholder is paying for stock, they get 4.2 cents in earnings.

Companies pay out a portion of their earnings to shareholders as either dividends or share buybacks. (There are some differences between these mechanisms for tax purposes, but that really does not matter for this analysis.) Suppose that they pay 70 percent of their profits out to shareholders, which would be the high end of the recent range. This would mean that shareholders could get annual returns from direct payouts of 2.94 percent (0.7 * 4.2).

The other component of returns is capital gains. The actual course of the market over the next decade is anyone’s guess, but one thing we can say with absolute certainty is that if the price to earnings ratio remains constant, then share prices will rise at the same pace as corporate profits. And, we do have projections for the growth of corporate profits over the next decade.

The Congressional Budget Office projects that before-tax corporate profits will grow at an average annual rate of 4.15 percent over the decade from 2020 to 2030. It makes sense to use before-tax profits, because we don’t know what will happen to corporate tax rate over this period. The 2017 tax cut hugely reduced corporate taxes, however it is possible that if Trump is re-elected he will seek to reduce corporate taxes even further. On the other hand, all the leading contenders for the Democratic presidential nomination have pledged to raise corporate taxes, in most cases by quite a bit. Without knowing the outcome of these political battles, it is probably safest to assume the tax rate remains where it is currently.

This gives us an average annual nominal capital gain of 4.15 percent.  The average inflation rate projected for this period, as measured by the consumer price index, is 2.4 percent, which gives an average real capital gain of 1.75 percent. If we add that to the 2.94 percent return from dividends or buybacks, it comes to 4.69 percent. This is considerably below the 7.0 percent historic real return on stocks, that many investors bank on.

Of course, these are very crude calculations. No one knows that the price to earnings ratio will stay stable. Suppose it were to keep rising enough to give 7.0 percent real returns over the next decade. In that case, using the CBO profit projections, the price to earnings ratio for the S&P 500 would be over 30 by 2030. That is not obviously impossible, but the 70 percent dividend/buyback payout would get shareholders just 2.3 percent of the share price. That would mean to sustain a 7.0 percent real return, price to earnings ratios would have to rise even more rapidly in the following decade.

The situation would look even worse with the broader market. Starting with a price to earnings ratio of 26.5 to 1, the price to earnings ratio for the market as a whole would be over 35 by 2030. That would provide a dividend/buyback payout of just 2.0 percent.

It is possible that profits could grow more rapidly. For example, the Trump administration could be proven right and maybe we will see 3.0 percent real growth over the next decade, but there are not many people betting on that being the case. We could see a further shift to profit shares, although with profit shares already at an unusually high level, that does not seem likely. There could be further cuts in corporate taxes, but with the effective corporate tax rate projected at less than 11.0 percent in 2020, that seems unlikely even if the Republicans remain in power. In short, it seems almost inevitable that real stock returns over the next decade will be considerably lower than their long period average of 7.0 percent.

However, the 4.7 percent real returns that would be consistent with a constant price-to-earnings ratio is not necessarily bad in the current interest rate environment. Historically, the real return on long-term Treasury bonds has been close to 3.0 percent. By contrast, the current interest rate on a 30-year Treasury bond is roughly 2.0 percent, putting it slightly under the inflation rate. A 4.7 percent real return on stocks does not look bad in a context where the long-term Treasury bonds are providing a zero or small negative real return.

But even if a 4.7 percent real return might be reasonable in the current interest rate environment, it is not clear that it is consistent with investors’ expectations. Many investors are undoubtedly looking at the far higher returns of the years since the Great Recession and expect double digit returns to continue for at least the immediate future. They may be very disappointed if this turns out not to be the case.

The other part of this story that stockholders have to consider is that there are good reasons for thinking that future after-tax profits might be considerably lower than CBO has projected. On the before-tax side, there was a large shift in income shares from labor to capital in the immediate aftermath of the Great Recession. As the labor market has tightened, there has been some shift back towards labor. The CBO projections assume that this reversal does not continue. In fact, the projections assume that the profit share of national income actually increases slightly over the decade.

The other key factor in determining after-tax profits is the corporate tax rate. This is of course a political decision. While Republicans are unlikely to raise corporate income taxes to any substantial extent, they also are unlikely to lower them further. By contrast, there is widespread agreement among Democrats that corporations should pay more in taxes. Whatever the outcome of the 2020 elections, there is at least a reasonable prospect that corporate taxes will increase at some point over the next decade.

With the possibility of further shifts back from capital to labor and future increases in the corporate income tax, stockholders should view their investment as somewhat risky. If the labor share were to rise back to its pre-recession level, profits would drop by 10 percent, if price to earnings ratios were unchanged. That would wipe out more than two years of returns, as calculated above.

The same would be true if there was a 9.0 percentage point rise in the effective tax rate to 20.0 percent, roughly the level prior to the 2017 tax cut. That would also lead to a 10 percent drop in share prices, assuming a constant price to earnings ratio.

And, the interest rate on government bonds could rise. Most economists have been surprised that long-term interest rates have remained this low for as long as they have. The low rates could continue, but no one can rule out that they will rise back to their historic average of 3.0 percent real rates. If that were to be the case, a 4.7 percent real return in the stock market may not look very good.

In short, there are good reasons for thinking that current valuations in the stock market are high. That doesn’t mean that prices will plummet any time soon, but it does seem unlikely that anything like the recent growth will continue far into the future.

[1] The value of corporate equities comes from the Federal Reserve Board’s Financial Accounts of the U.S. Economy, Table L. 223, Line 10. After-tax corporate profits are taken from the Bureau of Economic Analysis’ National Income and Product Accounts, Table 1.12, Line 15.

  1. Ikonoclast
    February 25, 2020 at 10:10 pm

    It is intriguing and somewhat disturbing that a great big black swan has landed on our far from placid economic lake. Its official name is COVID-19, Coronavirus 2019. Its taxonomic name is SARS-CoV-2, Sudden Acute Respiratory Syndrome – Coronavirus 2. One could shorten it to SARS 2, which evokes what this virus really is.

    This is one of those exogenous shocks which economics and natural human optimism and blindness ignore as a possibility until it is upon us. The term “exogenous” is relative to where one draws system boundaries. Conventional economics draws a system boundary between the economy and the natural world and draws it in a manner which is the antithesis of genuine system thinking and genuine scientific thinking. To conventional economic thinking, the natural world is a boundless given which provides an infinity of resources, bioservices and waste sinks. As I like to say, two of humanities biggest failings (in the current economic “knowledge” paradigm) are that:

    (a) people do not understand the import of exponential growth; and
    (b) people confuse “big” with “infinite”.

    Something which is big can appear infinite when we stand a long way from its limits. Exponential growth can and does bring a rapid approach to big limits and can rapidly make them look small indeed.

    Squeezes like limits to growth and shocks like climate change (when tipping points are reached) and viral outbreaks are not really exogenous when we view the biosphere as a connected whole system and the economy as a sub-system of the biosphere interacting with other its sub-systems. Such shocks then appear as predictable feed-backs. That is to say they are predictable to science although not predictable it seems in conventional economics.

    It has long been predicted by science that we would face another pandemic of the proportions of the Spanish Flu. It is still too early to say whether SARS 2 will be this pandemic. It is on the cusp of being declared a pandemic by the WHO functionaries who like everyone else in positions of power and influence in the modern political economy are patently conservative, reactive and well behind a clear and timely understanding of real events.

    A certain amount of statist and scientific preparation for such events had been put in place over time. The C.D.C. is an an example. Then it was eroded by the cost cutting of neoliberalism which we may correctly characterize as the shifting of accumulated wealth and income from the poor and public need to a tiny minority of the super-rich. We have been encouraged to consume excessively and to produce for immediate consumption rather than consume more modestly, preserve environments and produce sustainably for long-term needs rather than short-term greeds. We may characterize this as a system which produces more cruise ships than it should and less hospitals than it should. This is apposite as cruise ships are floating disease incubators seemingly designed, along with mass air travel, for the express purpose of shuttling dangerous diseases around the world as quickly as possible. The “Diamond Princess” is/was a case in point.

    The shut down of Chinese production along with the dependency of global supply chains on China and the use of JIT (Just In Time) inventory systems, now looks likely to lead to a severe global recession, if not a depression. Just as exponential resource use and abuse of waste sinks leads to a collision with natural limits, so do an excess of economic inter-connectedness and human mobility around the globe lead to feed-back limits appear as destabilizing ruptures and tipping points which appear seemingly unpredictably as black swan events. Some black swans really are predictable in that they will appear sooner or later. It is just the timing which is uncertain. If we do certain things, certain kinds of black swans will certainly turn up, sooner or later.

    The problem is the macro-management of the economy (or economies) by economics itself. The correct tools for management are science, ethics and democracy. In a capitalist political economy the rich (the stockholders) rule. What is required that all people must rule collectively albeit by making decisions in a science-informed, ethically informed and democratic manner. This is not pie in the sky. Science, ethics (humanist and theological) and democracy all exist currently. Admittedly they are all imperfect and vary country to country but we should never let a quest for impossible perfection prevent us from utilizing what is already practically useful and good.

    In order to give science, ethics and democracy more room for operation all we have to do is reduce the power of wealth, the power of the rich stockholders, to make decisions for all of us. We could begin by heavily taxing the rich once again (it’s been done before), by breaking up monopolies and private corporate fiefdoms and progressively introducing workers, citizens and the dispossessed on to boards. Models, past and present, exist for doing this and doing it in a relatively gradualist but long-term committed manner. It’s known in medicine that removing a large load of parasites sometimes has to be done in a gradualist manner or it kills the patient.

    Of course, we may not have time for gradualism. The world’s situation is dire. We are close to limits, to collapse and to dangerous tipping points related to climate change and other phenomena. As crises appear we may have to speed up the process dramatically. These crises must be used by the people. Capitalism is adept at using crises and disasters of its own making (sabotage and disaster capitalism as outlined by writers from to Veblen to Klein) to redistribute wealth from the bottom to the top. Capitalism is not geared to deal with shocks endogenous to its own formal wealth-power system. Real world shocks which undermine the productive basis of capitalism and its entire range of assumptions will challenge capitalism itself and make it ripe for collapse and change.

  2. Scott Baker
    March 2, 2020 at 9:48 am

    As the economist William Lazonick tirelessly points out, the majority of corporate profits – over 90% – got buybacks and dividends. This has the effect of expanding the earnings per share by reducing the share count, thus lowering the P/E. Of course, Lazonick is also correctly alarmed by the lack of money remaining for R&D, worker training and hiring and expansion of business, and anything else that might actually make the economy grow.
    But this is the Republican playbook: pump lots of money into the stock market with cuts to the rich and rich corporations, keep interest rates low so that these same people can finance buybacks with low interest debt, and hope that somehow, the Trickle Down Fairy will create new jobs and income.
    The buybacks are certainly happening – virtually all of the corporate tax cuts went to that – but the era of low interest rates goosing faux earnings may be coming to an end.
    Real debt in the real economy is exploding, and consumers are failing to pay their bills again, just like in 2008. We know what comes next.

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