Han Dieperink: A lost decade
Han Dieperink: A lost decade
This column was originally written in Dutch. This is an English translation.
By Han Dieperink, written in a personal capacity
Goldman Sachs published a report last week saying that the era of great stock market returns is over. The S&P 500 will return only 3 per cent a year for the next 10 years after adjusting for inflation. Are we heading for a lost decade?
The report (and especially the 'Lost Decade' in the title) is, of course, mainly designed to attract attention. Wall Street publishes masses of research and most reports disappear into the circular archive without having any impact on the market at all. But if it comes true then the next decade will be one of the worst 10-year periods since the Great Depression of the 1930s.
Concentrated market
At the heart of Goldman's outlook is the unusual concentration of the market in a few top stocks, mainly the Magnificent Seven. According to Goldman, the market is more concentrated than in the past 100 years. It is extremely difficult for such large companies to maintain high levels of revenue growth and profit margins over an extended period. Consequently, Goldman sees the market as overvalued based on the CAPE ratio, an earnings cycle-adjusted P/E ratio, a measure that uses average inflation-adjusted earnings over a 10-year period. Goldman points out that this CAPE ratio of the S&P 500 is at 38, indicating the 79e percentile since 1930.
Now, the CAPE ratio is much higher than the current (ordinary) price-earnings ratio. For instance, the P/E ratio of the S&P 500 is currently around 21 times. The Magnificent Seven averages 28 times earnings, which is not even that high given the spectacularly positive revenue and earnings surprises. The S&P 493 (i.e. the S&P 500 minus the Magnificent Seven) stands at a paltry 17 times earnings. Even if Goldman were to be right, the opportunities in terms of valuation therefore lie in the S&P 493.
The Technology sector and the Communications Services sector, formerly called telecoms, together now comprise about 40 per cent of the S&P 500, about where they were at the height of the dotcom bubble. Goldman may be overlooking the huge scope of technology in the wider economy. Today, almost all companies can be seen as technology companies. Technology is not just a sector in the stock market, but an increasingly important source of higher productivity growth, lower unit labour cost inflation and higher profit margins for all companies. High margins also largely explain the level of the CAPE ratio. Incidentally, the ratio's creator, Professor Robert Shiller, himself indicates that CAPE as a measure is in need of revision.
Rating is not suitable for timing
The problem with pointing to valuation is that markets can remain overvalued for longer. Even in the dotcom bubble, Goldman pointed to high valuation as early as 1998, and in late 1999 Goldman's partners even went short en masse, only to be smoked out less than two months later. Famously, then, Keynes said that 'Markets can remain irrational longer than you can remain solvent'.
Still, one of Goldman's recommendations is interesting. According to Goldman, it is better to invest in an equal-weighted index rather than the market capitalisation-weighted index. In the case of the S&P 500, there are several ETFs that invest in the S&P 500 equal weight. The advantage of such an equal-weighted approach at the moment is that it puts more emphasis on cyclical sectors, just at a time when investors are moving away from the recessionary scenario and becoming more attentive to cyclical stocks, while many of these cyclical stocks are still valued at recessionary levels.
Alternative scenario
The current environment is very similar to that in the 1990s and that in the 1920s. Those periods were followed in both cases by a long period of below-average returns. The big difference, though, is that today's valuation is much lower than then. Now that valuation consists of two components, the absolute price level and the profit level. Profit margins are higher than ever due to several reasons that will not go away anytime soon. The market power of the Magnificent Seven is so great that they are effectively monopolies or have each at least become part of an oligopoly. In fact, the power is so great that Big Tech is now more powerful than the president of the United States. Don't think Trump or Harris will go hard against these big tech giants. Moreover, the sum-of-the-parts break-up of these tech companies is probably good news for existing investors. Furthermore, there will be plenty of investment in the coming years.
To get to valuation levels of the peak of the dotcom bubble or the Nifty Fifty, the stock market - especially the Magnficent Seven - has to double first. That is even a conservative estimate, because the big difference with the dotcom bubble and even the Nifty Fifty is that sales and profits of these big companies are not only growing rapidly, but also comprise a growing part of the economy. If the US and global economies continue to grow over the next decade, profits will also continue to rise. Thanks to the deflationary effect of artificial intelligence, inflation remains largely under control, which also allows interest rates to remain relatively low.
In conclusion, all the ingredients for a bubble do exist: a paradigm shift, a promise in the distant future, a broadening of the market theme allowing more investors to invest in such a bubble and increasing liquidity (see also Charles P. Kindleberger's book: Manias, Panics, and Crashes, A History of Financial Crises). Increasing liquidity was triggered with the first interest rate cut in the US.