SOCIAL TOPICS: INVESTMENT & ECONOMIC ANALYSIS

Published, Spring 2001

       In July 2000, we wrote of the wide valuation disparity that had developed between the high growth technology stocks of the “new economy” and the rest of the market or the “old economy.” Our view was that the 25 to 30 percent growth required to justify the valuations of the large new economy stocks was not realistic in the context of an overall economy growing at a rate of only 6 or 7 percent. We predicted that prices of the large, expensive stocks of the new economy had to fall, perhaps painfully, in an adjustment to more realistic growth expectations. Conversely, we saw opportunity in the broader market where valuations of many companies were modest relative to reasonable estimates of future growth.

       This forecast proved to be right on target in the last four months of 2000. Technology stocks fell by 45 percent while the overall market as measured by the Standard & Poor’s (S&P) 500 index declined by 13 percent. Technology accounted for more than 100 percent of the decline in the overall market. That is, the rest of the market actually increased by about 2 percent in the last four months.

       Where does that leave us today? Although we have experienced significant valuation adjustment, there may be more to come, especially as we confront a potential economic recession for the first time in nearly a decade. But while the short run is indeed important, it may be less so than what is likely to happen in the long run.

       In the 90s, stock prices advanced dramatically. For the ten years ending in 1999, the S&P 500 provided an annualized rate of return of 17.5 percent. Stocks were in high demand with many investors buying based on price momentum alone. In the recent case of most dot.com companies, there was little regard for the economic value of stock ownership—making for actions more akin to gambling than to investing.

       In contrast, at Walden we have emphasized an approach to security selection that seeks to identify the economic value of a company. Assessed from this perspective, a stock’s value depends on the future cash flows the company can generate for investors.

       Prices for any stock or for the market overall will depend on the extent to which earnings grow as well as changes in the value investors place on those earnings. In the last decade, earnings (profits) grew faster than the overall economy, by taking a larger share of total output. During this period, the economy (gross domestic product, or GDP) grew by 5.5 percent per year and profits by 9.6 percent per year. Profits as a percent of GDP went from 4.6 percent in 1990 to 7 percent in 2000, high relative to recent history. In the last 40 years profits have grown at the same average rate as GDP, at 7.5 percent per year, and profits’ share of GDP has ranged from 4 percent to 7.6 percent.

       If, over the next 10 years, nominal GDP grows at 7 percent and profits’ share of GDP reaches 8 percent (a new high), then profits could grow at 8.5 percent per year. If on the other hand, profits’ share of GDP declines to 6 percent, then profit growth could only amount to about 5.5 percent per year.

       What about the valuation of those profits (earnings)? The price-to-earnings ratio (P/E), a yardstick for stock valuation, has ranged from 7 to 29 for the S&P 500 and currently is 23, with the lowest P/Es realized in times of high inflation and high interest rates. Given the low to moderate inflation and interest rates we anticipate, we believe that 23 is a reasonable future P/E within a range of 18 to 27 for ten years hence. If the market P/E increases to 27, it will add 1.5 percent to the average price return. A future P/E of 18 would subtract about 2.5 percent from the average rate of return.

       In conjunction with a modest dividend, the expected growth and valuation factors combine to produce average annual expected stock market returns of 8.5 percent over the next decade, ranging from 5 percent to 11 percent, as shown in the Table below.

       Significantly higher returns than these would require more rapid profit growth, potentially with negative implications. After all, profits are simply what is left after paying for labor, materials, power, and taxes. At 7 percent, profits are close to their highest share of our gross domestic product. It is reasonable to question just how far this trend can, or should, continue. This is not just a question of economics. It is linked to the pressing issues of America’s widening gap in income distribution and the appropriate share of the economic pie due to owners of capital, rather than to workers. There is little doubt that in the long run, economic growth that is not shared more equitably will prove to be unsustainable. Viewed in this light, a return to more modest stock market performance expectations would be a healthy change.—Bob Lincoln