“The market can stay irrational longer than you can stay solvent.” – John Maynard Keynes
The S&P 500 has shot up 7.5% since November 1st. Why? Some have called it the “#TrumpRally”, but much is due to the anticipation of a sharp decrease in the corporate tax rate, and positive economic surprises. To get a feel for what is driving stock prices I began an accounting exercise to attribute changes in S&P 500 to its many factors which include inflation, population growth, real GDP, and corporate profit margins before tax, and price multiple. I conclude that the market is pricing in about a 10% decrease in the corporate tax rate, partially offset by a 2.5% decrease in earnings from the rise in the dollar (7.5% = 10% – 2.5%). This accounting approach is consistent with my view that markets are generally efficient, but put a premium on easily quantifiable factors that are likely to occur in the near term.
What we have below is a simple decomposition of an equity index price (P). The level of the S&P 500 index, or any index, can be separated into the product of earnings (E) and the price-earnings ratio (P/E).
Earnings can be further broken out into GDP and Earnings as a percent of GDP. Notice that the earnings (i.e. profits) that matter are after tax (1-t).
GDP can be further broken out into inflation (I) and Real GDP.
RGDP can be further broken out into population growth (Pop) and Real GDP per Capita (i.e. Productivity growth).
Finally, we break RGDP into sustainable (RGDPS) and short term credit expansion/contraction (C). Credit allows RGDP to fluctuate around potential. We combine household and business into the same factor (C), but will examine both.
This formula allows us to account for changes in a stock price index. Each factor (blue boxes) includes both realized changes and changes in expectations. For short term changes, like what we have observed in the past month, realized changes can largely be ignored because very little has actually changed! Therefore, when looking at short term changes in stock prices the key question is, “What changes in expectations contributed to the change in price?”
To answer this question we also need to specify a time period for considering changes in expectations. Are prices dependent on expectations for the next year, five years, or ten years? For our purpose I will assume that stock prices generally reflect expectations for the next year. The reality may be quite a bit shorter given the shortermism bias that dominates the incentives of most players driving capital (as discussed in this previous observation). However, there is good reason to think that even very short term (1-3 month) forecasts take into account some longer term factors (like inflation). This is because expectations of future value are iterative. What I expect a stock to be worth depends not only on what will happen over the next 3 months, but also on what future expectations will be at that time. In other words, short term forecasts of stock prices still need to account for longer term factors.
By reviewing each of these factors we can get a sense for what could explain the 7% price increase. If no reasonable explanation can be found within the factors (blue boxes), than we are left only with the price multiple P/E (red box). The implication here is that if one was uncomfortable with the price multiple before than they should be even less comfortable now if the increase in price cannot be attributed to the factors (blue boxes). Likewise, if one was comfortable with the price multiple, and the increase in price can reasonably attributed to the factors, then they should still be comfortable with the new stock price.
Let’s take each of these factors in turn.
Inflation Expectations (I)
Inflation expectations for the next five years have increased by about 0.2% since early November. Forecasts of inflation for 2017 have increased by roughly the same amount. We can therefore attribute about 0.2% of the run up in stock price to changes in inflation expectations. This one statistic shows the “Trumpflation” theory to be flawed. In reality, inflation expectations explain very little of the increase in yields (which is up 80bps) and the S&P 500. [Source]
Population Growth (ΔPop)
Could population growth expectations have increased since Nov 1st? Perhaps, but this would be highly speculative. One could speculate that tighter immigration policies will actually reduce our current growth rate below its current level of about 0.75% per year (below). Also given that stocks rose it seems reasonable to assume market participants do not considering the impact that changes in immigration or other influences on population growth. This would be consistent with the markets bias toward quantifiable (i.e. data driven) factors and shortermism.
Real GDP Per Person
Real GDP per person is the most widely used measure of a country’s prosperity. Note that the explicit use of credit (C/Pop) is consistent with the Ray Dalio theory on economic growth. This theory stands in contrast to traditional economic models which rely on production functions, Total Factor Productivity, and other implicit “equilibrium” assumptions (i.e. no output gaps). Dalio’s theory assumes that business cycles are largely determined by expansions and contractions in credit.
Let’s take each factor of Real GDP per person in turn:
Sustainable RGDP is a through the cycle measure of a country’s productivity. It’s the economic growth rate per capita that we are most likely to experience without any expansion or contraction in credit. Recall that credit is the mechanism by which RGDP fluctuates around its sustainable level. This is illustrated by the red arrow below. Note that we have been on a downward trend since around 1985. The reasons for this were discussed in my prior observation titled, “Why Growth Fell”.
This downward trend is more obvious when we look at the RGDP output gap. [Source]
Today we stand at about 2% RGDP. As discussed in my prior observation, the downward trend in growth is driven by long term factors that are difficult or impossible to reverse like an aging population, barriers to quality education, income inequality, and debt. While policy may be able to address some of these issues (ex. education, inequality, debt) the benefits would take many years to observe. Thus, it seems unlikely that the recent rise in stock prices has anything to do with increased expectations for improved sustainable growth.
Credit Expansion / Contraction
Could expectations for credit expansion have changed since Nov 1st? Perhaps. Debt service for both households and corporates are near all-time lows (bottom left). This means that households and businesses are paying out a smaller portion of the income to pay debt than ever before. This also means that they could increase their borrowing. However, this was true before the election. Consumer credit growth has been on the rise since at least 2011 (bottom right). Thus, an increase in expectations of additional credit growth probably didn’t have much to do with the rise in stock prices.
What has changed is borrowing costs. Mortgage rates have increased 17.5% since Nov 1st (bottom left). This rapid rise in rates will increase debt service (top right) even if consumers don’t start to borrow more money. Mortgages make up the largest part of consumer debt (bottom right). The impact of rising borrowing costs on mortgages will be muted by the dominance of fixed rate mortgages, but the impact on credit cards, auto loans and other consumer debt will show up over the next year. For debt service of households and businesses to get back to their 2004 levels borrowing costs only need to rise by about 15% (different between green line and red line in top left). While credit had plenty of room to expand on Nov 1st, much of this has been erased by the shock to borrowing costs. For these reason, expectations for consumer credit expansion should have been revised down, not up, since Nov 1st.
Profit Margins Before Tax
Profit margins before tax have a direct impact on earnings. When profit margins rise then earnings rise. When earnings rise and the price multiple (P/E) stays flat then the stock index price will rise. Profit margins for an index are typically measured as a share of GDP. This is not a perfect proxy, but is captures the ability of companies to retain a higher portion of rents from the economy which should correlate with actual profit margins.
Profits margins have historically ranged between 4-8% (see below). However, since 2000 corporate profits have risen to consistently over 9%. The most compelling reason for this is globalization. Somewhere between 1.5-2% of this rise is likely explained by revenues that were made overseas without being taxed at the 35% US corporate tax rate. The falling strength of unions and cheap credit may also be contributing to the rise. That said, it is clear that profits margins are quite high historically speaking.
Profits margins tend to have an inverse relationship to the unemployment rate. The reason is that when the unemployment rate is high wage growth tends to be low (see below). By paying lower wages corporations are able to control a greater portion of GDP. This is why corporate profits as a percent of GDP tend to peak roughly half way between recessions as illustrated by the 8 out of 10 triangular shapes above. The impact is most noticeable when the unemployment rate falls below 5%. At this point wage growth tends to rise more rapidly than GDP stoking inflation. To head off inflation the Federal Reserve raises interest rates which increase borrowing costs and cause credit contraction. This process is known as the Fed driven business cycle and is consistent with Ray Dalio’s “How the Economic Machine Works” (see attached observation).
Source: Thank you Matt Busigin! @mbusigin
Given where we are in the business cycle it would be very unlikely for profit margins before tax to increase. To the contrary, we should expect profit margins before tax to fall as tightening labor markets lead to higher wages. Of course, the labor market in the US is not the only labor market used by S&P 500 companies. A growing percent of revenue in the S&P 500 is coming from overseas. Estimates range from just under 50% to 31%. This fact creates a problem for our measure of profit margins. Corporations make profits from many countries (numerator) and we are viewing it as a percent of USA only GDP (denominator). GDP only includes the monetary value of finished goods and services within a country’s borders. By this measure, profit margins would increase if corporations generated more profits overseas, even if USA GDP remains constant. Therefore, before concluding that profit margins before tax are unlikely to increase we need to consider whether margins could rise from increasing trade which would increase share of profits from overseas.
Forecasting higher profit margins based on the expectation that trade will improve seems far-fetched in today’s anti-trade climate. Since Nov 1st there has been some improvement in global trade expectations. This is indicated by the IMF’s World Trade Leading Index which showed a big improvement (3.5%) (bottom left). However, this effect is more than offset by the sharp rise in the dollar of 5.7% which acts as an immediate haircut to the value of profits made in foreign currencies stated in terms of the dollar (bottom right). For profit margins before tax to increase the growth in profits in foreign currency terms would need to improve by more than 5.7% just to maintain their currently elevated levels. Is this likely to occur over the next few years? I find it hard to imagine how trade could improve given the many rapid-fire changes (ex. Brexit, No TPP) and geopolitical uncertainties (ex. Euro) in the world. More to the point, I doubt recent increases in the stock market are based on improving profit margins before tax for these reasons.
Profit Margins After Tax
In my view, the new expectation of corporate tax reform provides the only reasonable explanation for the surge in stock prices. Tax reform could theoretically increase corporate profits by as much as 20%. This is the simple math of reducing the corporate tax rate (t) from 35% to 15%. The impact to profit margins (as proxied by earnings after tax over GDP) requires no change in corporate earnings.
The impact of the reform will depend a great deal on the change in effective tax rate. It is far from a done deal so coming up with a precise impact on the corporate profit margin is not feasible. Corporations, however, are unlikely to receive a 20% reduction in their effective tax rate. The current effective tax rate for corporates is probably closer to 25-30% (not 35%) because of loopholes and revenue from lower tax jurisdictions (other countries). The new administration may only be able to reduce the rate to 20-25%. No one knows, but speculation is undoubtedly moving stock prices.
Stock prices are driven by changes in expectations of earnings and price. When examining large changes in price it can be helpful to break out factors that contribute to earnings. These include inflation, population growth, real GDP per person, and corporate profit margins before and after tax. Anything that cannot be reasonably attributed to these factors necessarily implies a change in price (i.e. higher price multiple = P/E ratio).
In examining factors contributing to the recent rise in stock prices I made the following arguments.
- Inflation – Very small positive impact: Inflation expectations only increased by about 20bp per year compared to a 80bp increase in interest rates.
- Population growth – Very small negative impact: Any change in expectations are too hard to quantify but probably very small. New immigration laws may have some effect, but this is highly speculative and probably didn’t have much if anything to do with recent increase in stock prices.
- Sustainable RGDP – Very small ambiguous impact. Expectations for a rise in sustainable RGDP probably haven’t changed. Factors contributing to sustainable GDP generally include long term trends that are difficult or impossible to reverse such as the aging population, access to quality education, debt levels, and income inequality. Even if new legislation is put in place to address these issues it will be years if not decades before there effects are realized.
- Credit Expansion / Contraction – Negative impact. Debt service ratios for households and corporates were at an all-time low before the election. This provided room for credit expansion. However, since the election the interest rates have risen considerably. Thus, expectations for future credit expectation should have been revised down. The fundamental problem here is that Americans are so heavily indebted that even a small rise in rates can dramatically increase debt service costs.
- Corporate profit margins before tax – Large Negative impact. The dollar has risen by 5.7% since the election. This acts as an immediate haircut to profits generated from foreign countries. Nearly half the revenue coming from S&P 500 companies comes from overseas so we should expect, all else equal, that S&P 500 earnings will fall by about 2.5% from this effect alone. Given where we are in the business cycle it seems likely that corporate profits margins, which are already nearly historical highs, will fall. Corporate profits as a percent of GDP tend to rise when the unemployment rate is high. This is because labor has a harder time competing for higher wages when there are many unemployed people willing to work for less. This year, 2016, power has begun to shift back toward labor as the unemployment rate fell below 5%. Higher wages cut into profit margins.
- Corporate profit margins after tax – Huge positive impact. Tax reform could theoretically increase corporate profits by as much as 20%. This is the simple math of reducing the corporate tax rate (t) from 35% to 15%. The effective corporate tax rate is closer to 30% and the new administration may only be able to get the rate down to 20%. However, this still provides a 10% windfall to corporate earnings. Expect volatility in stock prices one the debate over the corporate tax rates gets underway.
The biggest and most objective contributor here is the corporate profit margin. The surge in the dollar will reduce earnings before taxes by 2.5%, all else equal. However, this is more than offset by the expectation of a corporate tax break which could increase after tax earnings by anywhere from 5-15%. If we assume a 10% increase in after tax profits and a 2.5% haircut do to the rise in the dollar than we arrive at the 7.5% increase in the S&P 500 since Nov 1st.
Accounting for stock price movements is obviously very difficult to do objectively and should be subject to scrutiny. The point here isn’t to try to make precise estimates. The point is to recognize that changes to stock price indexes must be attributable to either earnings or prices. Earnings are a function of inflation, population growth, sustainable RGDP per person, credit expansion/contraction per person, and corporate profit margins before and after tax. When stock prices rise and fall I ask myself about each of these components. If no reasonable explanation can be attributed to these factors, then all that has changed is the price.
In order to account for stock price movements one has to try to account for earnings. Earnings are a function of the economy, and the economy may be the most complex social construct ever created. Obviously we cannot forecast economic growth or its many components with any reasonable degree of accuracy. That is not the point of this exercise. The point is to determine what expectation is embedded in the price. Without knowing what expectation is embedded in the price of an asset one cannot make an informed decision about whether to invest in said asset.
Feel free to share your own thoughts on understanding changes in stock index prices. There is no better compliment you can give us than your thoughtful criticism. You can reach us at firstname.lastname@example.org, or follow us on Twitter @intuitecon
Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.