In the world of investing, no phenomenon is more remarkable than the tendency of Wall Street’s brilliant, richly bonused prognosticators to make totally wrongheaded forecasts for stocks. Here’s the typical sell these days: Start with sober, logical-sounding parsing of numbers and trends that point to danger ahead, but then draw the familiar, and absolutely opposite, conclusion—this aging bull will just keep roaring!
Just this week, Goldman Sachs’ chief global equities strategist followed the script. In a CNBC interview on Tuesday, Peter Oppenheim noted “the fundamental peaking of growth momentum” and cautioned that the Trump bump has “overpriced the ability of the administration to push through some of the things the market is priced for.” He also forecast that a chance of a “correction,” normally defined as a drop of at least 10%, is “quite high.”
At that point, his portrait of a severely stretched, overpriced market made perfect sense. But then Oppenheim veered to a confounding conclusion: “The correction—if we’re getting one—is not going to be the end of the bull market. I think that will probably continue for some time.” In other words, any drop will be temporary; stocks will then resume their upward march, breaching today’s near-record levels and rising from there.
Now don’t get me wrong. Oppenheim’s analysis is excellent and his warnings are well founded. But with all those caveats, how can he and his Wall Street brethren remain so doggedly optimistic?
At today’s elevated prices, the market math contradicts Wall Street’s sunny outlook with three possible scenarios, that are best illustrated by popular songs with divergent themes.
The first is what I’ll call the “Wall Street fantasy” outcome recalling the inspirational standard from Man of La Mancha, “The Impossible Dream.” The second is the plodding, “mediocre” path suggesting Irving Berlin’s 1940’s tune “Getting Nowhere.” And the third is the “disaster” scenario that could be subtitled, “I’m Building Up to an Awful Letdown,” a 1930s ditty immortalized by Fred Astaire.
Wall Street Is Crooning “The Impossible Dream”
As Oppenheim acknowledges, equity prices are rich. On March 28, the S&P 500 stood at 2341, up 9.8% from the eve of President Trump’s surprise victory. The price-to-earnings multiple is a lofty 24.6.
Here’s the problem: Delivering high returns from this plateau requires super-charged earnings growth, for two reasons. First, dividend yields are extremely low at just below 2%. Second, if investors are expecting returns even in the high-single digits, they’re automatically saying that the equity cost of capital, represented by the gains they’re expecting, are also high.
A high cost of capital requires PEs that are low to moderate so that investors are getting a lot of dividends and reinvested profits for each dollar they pay for a stock. If the cost of capital is high, and so are PEs, multiples must drop sharply going forward. Under those conditions, only a rapid, exceptional expansion in profits can produce high returns.
To see how fast earnings must wax, let’s use a simple example. We’ll consider the S&P as one big stock—S&P Inc.—selling at $23.41 (moving the index decimal point two places to the left). Let’s say investors demand a total return, including inflation, of 8% annually. That’s no exaggeration, since pension funds frequently predict equity returns that big. We’ll also assume all dividends are reinvested in extra shares.
In five years, S&P Inc.’s price will need to rise 34% to deliver an 8% return; keep in mind investors hold lots of extra shares purchased with the rising dividend. Hence, its stock must reach $31.30 by late March of 2022.
That doesn’t sound so difficult. But it is, because S&P Inc.’s PE must also fall. We won’t get into all the math, but if the cost of capital is 8%, or 6% “real” before inflation, the PE will eventually settle at around 17. So at a PE of 17, S&P Inc. will need to be earning $1.84 a share in five years. Today, our S&P proxy makes 95 cents a share.
To reach an 8% return, the S&P must double its earnings per share. That would require an annual growth rate of 15%. Even if the PE settled at 20, profits would need to ascend at 11% a year. Forget about it. Profits can’t conceivably advance at a 13% real rate, from already high historic levels, in an economy growing at 2% or 3%.
It’s a pretty, stirring refrain. But it’s a double, Don Quixote fantasy, that’s both a dream and impossible.
“Getting Nowhere”: The Road to Mediocrity Could Be The Market’s Future
It’s altogether possible that investors no longer expect anything like 8% returns. Therefore, the cost of capital might be far lower. It may be that investors believe that the world has changed, that US stocks are now a slow-growth, low-risk, low-return, dull but stable place. In that case, the folks will be satisfied with relatively puny returns, anchored by a plodding, slow-moving economy.
Bolstering the “low expectations” theory is today’s PE of almost 25. If that’s the right number, and that extra-high multiple remains a constant, then the cost of capital is the inverse of the PE. That formula establishes an expected return of 4% “real,” or 6% including inflation. The return comes in three equal parts: profit growth of 2%, a dividend yield of 2%, and inflation of 2%.
Actually, 6% sounds decent given today’s slender interest rates. Unfortunately, it’s highly unlikely that one of the three pillars listed above—profit growth—will fully deliver. “Earnings for big companies have been growing well above the historic trend,” says Chris Brightman, chief investment officer for Research Affiliates a firm that oversees strategies for over $170 billion in mutual funds and ETFs. Going forward, he says, it’s probable that profits expand at a slower-than-normal pace. Historically, S&P EPS has risen at just 1.5% a year, trailing smaller jackrabbits that reinvest a higher proportion of their earnings at extremely high ROEs.
So here’s a more realistic prediction: a future return consisting of 4% from dividends and inflation, and 1% from EPS growth, for a total of 5%. Relative to Wall Street’s raging bull market hype, that’s getting nowhere.
Beware the “Awful Letdown”
It can’t be overstressed that earnings have been growing faster than the economy for five decades and sit at all-time highs vs. GDP, revenues, and shareholder’s equity. The trend not only can’t last, it’s likely to reverse. And that’s the anatomy of the disaster scenario.
Once again, let’s assume investors really require an 8% return to compensate them for the riskiness of holding equities, and the gyrations of late show that they’re really, really risky. That bogey means that the PE of S&P Inc. must eventually drop to around 17, using the same math as in the “impossible” chapter. Now, let’s also forecast that earnings rise just 2% a year, matching inflation. Put simply, they remain totally flat in “real terms.”
That’s a highly plausible outcome because it would simply obey economic gravity: Profits would decline to a more normal level in relation to such measures as national income. In this example, investors are still using dividends to buy more shares at declining prices. Once again, we start with the current S&P Inc. price of $23.41. By 2022, it would have fallen over 27% to $17. Even with extra shares bought with dividends, investors would suffer annual losses of 2.5% a year.
But then in 2022, new investors would fare far better. The dividend yield would have risen from 2% to 3%, for an increase of 50%, and profits would have returned to moderate levels, restoring headroom for growth. “It’s then likely that profits could rise from those lower levels at 3% to 4% a year, including inflation,” says Brightman.
That’s indeed an awful letdown. Asset managers and folks with 401(k)s would suffer negative returns for five years, and at the end only be able to reap 7% at best.
“The most likely outcome is somewhere in between the disaster and the mediocre scenarios,” says Brightman. The most logical projection is for low-single digit returns over the next decade. Crowing and crooning that the bull market will keep roaring is Wall Street bull.