Pascal Blanqué, the group CIO at Amundi, considers how the past teaches us lessons about what to expect when there is a divergence between earnings growth and market returns.
US earnings and equity prices have both risen at a reasonable pace in the past few years, with returns accelerating above long-term averages in the most recent period. To what extent is this sustainable and valid in the long run? We can derive some lessons from the past by looking at the historical relationship between changes in equity prices and in earnings.
A starting point could be a research report from the Kansas City Fed (‘What Long Term-Run Returns Can Investors Expect from the Stock Market?) published in 1997.
Why 1997? Because there are common points with regard to the current environment, such as global and US growth; talks of new tech revolution; bubbling segments in the markets; talks of structural change in the economy; Fed normalisation, etc.
This analysis shows that in the long run (1922-96), S&P500 equity prices and earnings both rose at an annual rate of 8%. However, from 1982, equity prices rose at an average annual rate of 13%, much faster than earnings and their long-term average.
Additionally, this analysis shows that in the past, these periods of equity prices rising above earnings have lasted 14 years on average and have been followed by periods when equity prices adjusted, rising at a lower rate than earnings. In fact, reversion to the mean would imply that periods of above-average returns are followed by periods of below-average returns, unless something structural lifts the average.
What happened from 1998?
The following years saw that mean reversion worked (2000-12), with prices rising less than earnings (and earnings rising below historical trend). Market returns were further depressed by the great financial crisis in 2008, which determined the realignment of the long-term trends in price and earnings growth, at around 7% in the 1970-2012 period.
What the recent years tell us? We are again in a phase of divergence between earnings growth and market returns. Since 2012-13 we have seen equity prices rising faster (14%) than earnings (no more than 5%).
Can the market continue to post these returns? With dividend yields of about 2%, to see a continuation of the last five-years trend in market returns, return to physical capital should also rise at an annual rate around 12%. This seems unlikely assuming the current trends in labour force growth, stock of capital and productivity, and the already high share of profits in the sharing of added value. In order to return to a phase in which physical capital and its return rise further, productivity gains would have to jump, with all else remaining constant, and this is unlikely at this final stage in the cycle.
However, the long-term analysis shows that markets can still go through relatively long periods of divergence. The current phase that started in 2012-13 could, in our view, continue for a couple of years, thanks in particular to US fiscal expansion, until the support from the cycle fades. A possible correction could, in fact, be triggered by a combination of higher bond yields and downward revisions to earnings expectations.
Again, just like in the late 1990s, investors cannot expect any miracle in this cycle, but just an extrapolation of a couple of years of good returns. And, again, they will have to deal with the great “narrative” on productivity and its measurement: If you cannot change reality, change how to measure it.
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