We have been hearing for years the US stock market is overvalued. Stocks are different than most things we purchase. I paid $36 for a cheeseburger earlier today. Everyone agrees that’s (ludicrously) expensive, because cheeseburgers are easily comparable. They’re all somewhere between 600-1,200 calories of carbs, fat, and protein packaged into a delicious experience. Is a stock trading at $36/share expensive? We don’t have enough information because it’s not clear what that $36 is buying. Companies are sliced into different numbers of pieces (shares). How much of that company (or, more accurately, how much of that company’s future earnings) does that one share for $36 entitle you to? Nvidia trades at $237/share and Walmart at $108. At first glance, Nvidia is more than twice as expensive as Walmart. But once we factor in their profits (the whole reason for buying shares of companies is owning a piece of their future profits), the picture changes. Based on Nvidia’s projected forward 12-month earnings (profits), an investor is paying $25 for $1 of the company’s future earnings. Walmart investors are currently pay $37 for the same $1 of future earnings. Which stock is really more expensive?
This analysis can be expanded to the stock market as a whole. You may have heard chatter during the present bull market that the S&P 500 is “expensive” or “overvalued.” Proponents of this opinion are typically referring to the price to earnings (P/E) ratio or the CAPE ratio. The P/E ratio is the same calculation used above for Nvidia/Walmart - how much an investor is paying for $1 of earnings at the index level. The CAPE ratio replaces the denominator with 10-year average inflation-adjusted earnings. This is meant to neutralize the impact of short-term business cycles and profit spikes. The S&P 500 currently trades at a P/E ratio of ~25 compared to a postwar (since 1946) average of ~17 and a CAPE of ~40 compared to a postwar average of ~20. We can see how some believe it’s expensive. We’re not so sure.
There are structural reasons for the S&P 500 to trade at a higher valuation relative to the past. The composition of the companies in the index has changed dramatically. In the 1960s the index was dominated by railroads, manufacturing, and oil. Capital intensive, low margin, highly cyclical businesses. Standard Oil, Eastman Kodak, General Motors, and Texaco were among the top ten constituents. Today the index is driven by high margin capital light businesses that have proven resilient to changes in business cycles. These businesses print profit margins at levels unfathomable a few decades ago. Nvidia, Apple, Google, Microsoft, etc.
Another structural reason for rising US stock valuations is explained by a simple formula:
Long-run GDP growth = population growth + productivity growth.
Apologies if that formula initiates any traumatic flashbacks to Econ 101. GDP is the sum of a country’s economic output. There are only two ways to increase economic output. Increasing the population (more people contributing to economic output) or increasing productivity (more output per person). Population growth is trending towards zero or negative cross the developed world. In these places, substantial productivity growth will be required to achieve even marginal GDP growth. In the US, deaths are projected to exceed births by 2030, though with immigration population will not peak until ~2060. Japan and China’s populations have already peaked and Europe will soon. Innovation drives productivity, the other half of GDP’s binary. Americans have led global innovation historically. Transistors, integrated circuits, smartphones, the internet, space travel, satellite technology, cutting edge medical procedures, shale, nuclear energy… Property rights, rule of law, deep capital markets, and a culture that celebrates entrepreneurship indicate this trend will likely continue.
So, among advanced economies, the US has both the strongest population dynamics and the best history of productivity growth. It is not particularly close on either front. This backdrop makes current valuations reasonable in our estimation. This brief analysis should not be confused for belief the US markets are immune to drawdowns. They certainly are not and never will be, as temporary drawdowns will always be a feature of equity investing across the globe. Though for long-term allocators like ourselves, we expect US equities to continue trading at a premium relative to the past and to other countries’ economies, and we happily pay it.
Sean Cawley, CFP®
Sources: Goldman Sachs: How Aging and Declining Populations will Drive Product and Company Demand Tailwinds/Headwinds
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