Can profits keep rising? Uncle Miltie said no (cont.)
The best bet is that earnings revert to their old levels, versus GDP. Hence, profits will either go flat for several years, or decline, as workers pocket the productivity gains that have swelled earnings.
Third, don't believe the TV pundits who say stocks are a bargain. In reality, they're extremely expensive right now. And buying in at high prices has always been the ticket to low future returns.
Today, the S&P is selling at a PE of around 18, based on the last four quarter's earnings. But remember, those earnings stand at a record level. "That makes stocks look cheaper than they really are," says Cliff Asness of AQR Capital Management, a highly successful hedge fund.
To really gauge how much you're paying for a dollar of profits, it's more revealing to compare today's prices with average earnings over the past ten years. That formula takes out the big swings in earnings that can make stocks look artificially under- or over-valued. By smoothing earnings, Asness gets an adjusted PE of around 25. That's close to twice the historic average of 14 or 15. And that's expensive.
Fourth, dividend yields are extremely low, frequently a signal that stocks are overpriced. They stand at 1.8 percent, less than half the average over the past century. One reason is that PEs are so high; another is that companies are retaining a higher portion of their earnings.
If they were reinvesting those earnings for huge returns, today's high prices might be justified. But research by Asness and Robert Arnott show that retaining more earnings leads to lower, not higher, profit growth. One reason: Managements have a tendency to squander retained earnings by overpaying for acquisitions.
So how fast do profits really grow over the long term, leaving out the lurching, feast-to-famine trend we've seen over the past decade? The best research finds that profits for publicly traded companies grow at less than 2 percent a year, adjusted for inflation. The reason they grow more slowly than GDP is that private companies are more profitable - tech and pharma players before they go public, for example.
Take the 1.8 percent dividend yield and 4.5 percent profit growth, including inflation, and you can expect to earn 6.3 percent or so on your portfolio going forward. And that's assuming that PEs stay where they are.
It's highly possible that PE's, and stock prices, will drop, raising dividend yields and giving investors a window to buy in at lower prices. It's only from far lower prices that stocks have a prayer of posting more double digit gains over the next several years, though as Friedman said, the stock market is totally unpredictable for any short period. That's what he called "noise." Take Uncle Miltie's advice: Don't mistake noise for fundamentals.
The Chicago contrarian
Friedman's views surprised me on several other occasions. In the 1980s, when the European Union wanted its members to adopt a single currency, Friedman told me, "There will never be a single currency in Europe." He thought that the huge differences in productivity between the member states would make the Euro an impossibility.
Of course, it happened. But Friedman's basic analysis was correct. The Euro is saddling less competitive members like France with what amounts to a highly overvalued currency, cutting growth rates and making it far more difficult to export.
On the medical market, I asked Friedman if he felt that supply-side, monopolistic restraints - such as restrictions on the doctor supply - were a major reason for the shocking escalation in health care costs. He said that while such restrictions on competition were an extremely bad idea, they weren't the main problem. The problem, he said, was that consumers spend only 20 cents for every dollar in medical care they consume, leading to huge over-consumption and total lack of interest in the prices they're paying.
In our last conversation, I asked for his view on entitlements, and whether they would absorb such a high portion of national income that America would fall into the European, slow-growth syndrome. That's the way the numbers are pointing, to be sure. But Friedman surprised me again. He pointed out that government spending as a percentage of GDP has risen and fallen dramatically several times since World War II. He felt that it would remain stable, or even fall again, in the future - despite the statistics stacked against him. "I'm optimistic," my idol kept saying.
He didn't feel the same way about the stock market. Neither should you.