Why Pessimists Missed the Bull Market

Economists' forecasts in recent years have got some things right, but missed the boom in US corporate earnings

John Rekenthaler 11 October, 2018 | 8:05AM
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Wall Street - US Investing

Since the financial crisis, share ownership has gradually declined. Retail investors have been unconvinced by the bull market of the last 10 years. Professional managers haven't exactly pounded the table with enthusiasm, either.

As is customary, stocks climbed the wall of worry. As is also customary, most of the public discussion was nonsense-, including unnecessary worries about political issues. Investment experts will talk at length about such subjects as election results, tax proposals, and budget negotiations.

To the first approximation of truth, those things never matter. Nobody who listened to fears about tax-policy "uncertainty" profited from that decision, nor has anybody in 2018 benefited from the trade war chatter.

What drives stock prices are corporate profits, which lie mostly outside government control, and inflation, which is perceived to be under government supervision, but which in reality is like an unherded cat. Forecasting the long-term fortunes of US stocks, for example, means leaving not only the Washington bubble but often the country entirely. The results are largely determined by global business trends.

And, in 2009, we misread what those trends would be.

The consensus was that the US economy would enter "the New Normal" – a phrase popularized by PIMCO's Bill Gross, although he was not its inventor – an era marked by sluggish growth and, for a while, dormant inflation.

After a few years, though, the government's efforts to stimulate the economy by "quantitative easing" and "fiscal stimulation" would likely spark inflation. The Federal Reserve would then need to tighten money supply, thereby reducing the already feeble growth.

Economists Predictions Were Half Right

In many respects, that outlook was correct. GDP growth has been subdued; inflation has been dormant, although for longer than was generally anticipated; and the ancillary predictions that global interest rates would remain low and China would increase its presence, economically and politically, came true. Today's investment world is much as the economists envisioned almost a decade ago.

But they missed one very big effect: in traditional economic terms, capital's victory over labour. Historically, economic booms have been quickly followed by economic busts, because workers rapidly progressed from being delighted to have a job, to thinking that they could do better, to demanding that they be paid more, lest they leave the company. Then would come the aforementioned inflationary pressures, the Federal Reserve would raise interest rates, and the cycle would turn.

Not this time. Corporate executives managed their labour costs splendidly – or wickedly, from the workers' perspective – thereby boosting their companies' margins beyond all expectations. In 2014, the S&P 500's profit margin exceeded the peak that it recorded during the previous economic cycle. It hasn't stopped rising. This year, despite repeated predictions that margins would revert to the mean, the S&P 500's net margin is its highest yet.

2018 Will Be S&P 500's Best Yet

Fat margins mean fat profits. In 2011, S&P 500 calendar-year earnings outdid those of every previous year, save for 2006. The S&P 500 then repeated that feat for each of the next six years, meaning that it posted seven-straight record or near-record results. This year, to replay the theme, will be the S&P 500's best yet.

The top line, as predicted by the economists, has been unimpressive. Superficially, the S&P 500's revenue growth looks acceptable, as the index eclipsed its pre-crash high in 2011 and, aside from a brief 2015 blip, has been rising since then. But those figures are nominal, not real. In contrast, the earnings statistics presented above are adjusted for inflation. On an after-inflation basis, the index's revenues required nine years, from 2008 until 2017, to reach a new high.

Credit to the prognosticators for getting that point right. Foreseeing that corporations would not grow their revenues as rapidly – indeed, barely at all for several years, after adjusting for inflation – as during previous recoveries was no mean feat. Doing so required a deep understanding of global economic forces, as well as the willingness to break from experience. Saying "this time is different" is a perilous task. Most market forecasters did so in 2009, and they were correct.

But they missed what would happen with the bottom line, badly. Setting aside the needless attention paid to political squabbles, the economic discussions have been sensible and mostly on target. The only major factor that was missed was the improvement in corporate profitability. Unfortunately for the accuracy of forecasters, although very fortunately for equity shareholders, that one item was so important that it overwhelmed the results.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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John Rekenthaler

John Rekenthaler  is vice president of research for Morningstar.