This has been a great growth year, but it hasn't been a great return year. Let's analyze the growth and return situation.
First, real U.S. GDP grew at just over 2% in the first quarter of this year, and just over 4% in the second quarter. Pretty good.
Growth expectations for the third quarter (final number is not available yet, only the first print of the estimate) are expected to come in at roughly the high 3% range. Also pretty good.
This means that it is quite likely that the first three quarters of 2018 will end up with roughly a 3.3% real, annualized growth rate. That's a lot better than we've seen for the past decade.
The S&P has done a bit better than 9% from end of 3rd quarter to date:
But when you take into account the big sell-offs early in the 4th quarter, the year-to-date performance is flat as of this writing.
So as of the end of Q3 the S&P was handily beating GDP but shortly thereafter plunged so as to not keep pace with GDP.
But does that mean it's keeping up with growth? Not really. Real GDP numbers have been annualized, whereas returns are not a full year. That helps the case that the markets are keeping up with growth. But Real GDP is REAL GDP, meaning not nominal -- it takes out the price effects of loss of dollar purchasing power. If we look at NOMINAL GDP growth (which is what we should compare to NOMINAL returns) we see:
A 4.2% and a 7.4% growth rate for the first and second quarters, respectively. Let's say that nominal growth, like real growth expectations, come mid-way between them. We get nominal annual growth in the mid 5% zone. Seems a bit low given that inflation has been rising, but that makes for a conservative assumption, meaning one that makes my view that markets aren't keeping up with growth a bit harder to establish.
Of course, let's remember that investors don't buy GDP, we buy business profits. So, what are those doing?
They are up 6% year-over-year in the first quarter and up 8% year-over-year in the second. That gives us roughly a 7% nominal YOY profit growth rate. As of this writing, returns are at less than 3%. Not keeping up with profit at all.
Let's look at quarter-over-quarter profit growth rates. Here's before tax quarter-over-quarter change, annualized:
It shows slightly more than 5% and more than 16% profit growth in the first and second quarters, respectively. Since investors are buying after tax profits, that's closer to the right benchmark. That's a greater than 10% annualized nominal growth rate in profits for the first half of the year. So far, the 4th quarter seems about on pace with 2nd quarter. If that's so, the growth rate for the year is very likely to be above 11%. Returns YTD have not come close to that return. Even returns year-to-Q3 fall significantly short of that. There is a close historical parallel between earnings growth and stock market returns. Why isn't it working now?
It's not working now because the yard stick of valuation is broken. The bridge idea between economics and finance is the interest rate. The interest rate is a key idea in macro-economics and it is also a key idea in finance. The interest rate is the baseline of valuation. When rates are low, that means that cash flow from the future is worth more now. That’s because the interest rate is an alternative source of gains. If bond yields are very low, that means that I'm more willing to pay more money for stocks because the alternative use of investment cash, bonds, is relatively unattractive. This idea is called 'opportunity cost' in economics and 'discount rate' in finance. But it is really the same idea. When deciding what price to offer to pay for a particular stock, investors estimate future dividend payments, but they also have to estimate the current value of those future dividends. Investors do this by looking at the alternative uses of their money, and so they estimate the present value of those shares of stock differently when the alternative 'risk free' interest rate is high than when it is low. It's tougher to get me to buy the equity lottery ticket when debt 'sure thing' is high.
A lot of commentary in the financial media about stocks and rising interest rates has focused on the fear that higher interest rates will make business less profitable, and then it is alleged that higher interest rates (or expectations of them) drive stock prices down because investors think that businesses will be less profitable. That effect is there in limited segments of the market and to a limited degree. But it is a much less important effect than the overall distortions of fluctuations in interest rates. The main issue is not that companies will have less money to pay out in dividends in the future: rather, it is that future dividends are worth less to us now if non-dividend alternatives like interest rates are going up.
Also, if rising interest rates were frightening markets because of an alleged profit effect, then we would be seeing both significant shifts in earnings expectations and in business managers’ optimism. But both ISM surveys, the manufacturing one and the non-manufacturing one, have been signaling increased optimism in 2018 and only very tiny decreases in the past couple of months.
Also, If the interest rate cost/profit squeeze theory was the only thing going on, then high-debt companies would be selling off at massively greater rates than low-debt ones. And lending companies would be rising rapidly during these interest rate hike scares.
Look at the Fed Funds data here:
What makes the most sense is that 2018 YTD return has fallen short of profit growth rates because future profit gets to be worth a little less in present time as the alternative, interest rates, become more attractive.
This is a big headwind in any market in which rates are low and likely to rise in comparison with one in which rates are high and likely to fall.