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Lots of people think earnings drive stock market behaviour. They’re partly right. Stock market behaviour is driven largely by expectations for earnings and, even more powerfully, by changes in those expectations. Accordingly, when earnings are running from one peak to another, ever-higher peak, investors’ expectations are very optimistic, and those expectations often falter. If enthusiastic optimism gives way to cautious optimism, that’s a change in the wrong direction. This is why bull markets end when people are still optimistic, while the opposite holds true at market lows.

Where do we stand today? Earnings, both in the US and globally, are at an all-time peak, whether measured in notional or real (net of inflation) terms. As often happens at such times, investors are broadly optimistic about the prognosis for future earnings gains, just as they are pessimistic when earnings are dreadful. Is that optimism well founded? And, more importantly, are we likely to see that optimism survive or falter?

Many observers point out that, following an unprecedented peak in valuation multiples (price-earnings ratios as well as price-sales, price-book and price-dividend ratios) at the peak of the bubble in 2000, p/e ratios are now back down to their long-term historical norms. That’s true. But that’s only because prices and earnings are both well above their historical trends.

Most observers focus on the near term for share prices. Instead, think long term and focus on earnings. Over the next 10 or 20 years, what is in store for earnings? During the past 136 years, US earnings have risen 1.5 per cent faster than inflation. In most of the developed world, real growth has been slower than this, in the 1 per cent real growth range. Add in typical long-term inflation expectations of 2-3 per cent and we’re looking at 3-5 per cent nominal growth in earnings. This is below consensus earnings growth expectations; such growth would disappoint, in which case current optimistic expectations may fall. But that’s the norm. With peak earnings, what should we expect?

There is a very long history of real prices and real earnings moving in a surprisingly consistent – and parallel – corridor around a long-term growth trend, albeit with large swings in prices, earnings and the p/e ratios.

There’s also a long history of reverting back to the trend. When earnings are 40 per cent or more below the trend (2002, for instance), subsequent real earnings growth averages about 10 per cent – over and above inflation – for the next 10 years, which is terrific. When earnings are 40 per cent or more above the trend, subsequent earnings growth tends to disappoint, with average real growth of zero – just matching inflation – over the next 10 years.

Where are we today? Both prices and earnings are 60 per cent above trend. This suggests either that things are different this time, that prices and earnings have built a base from which to leap to new heights, or that both may disappoint.

If the five most dangerous words in investing are “things are different this time”, “history repeats” can be almost as dangerous. Past is not prologue. As Kurt Vonnegut said: “History is merely a list of surprises. It can only prepare us to be surprised yet again.” When earnings have hit historical peaks in the past, they have been disappointing in the subsequent years. We do well to recognise that earnings may disappoint in the years ahead, and that shifts in expectations are the main mechanism that moves markets.

Of course, we’d be merely setting a new – and higher – foundation for future real growth. But consider that, at least in the US, wages are the smallest fraction of gross domestic product in history and that profits are at a 40-year high. Would there be a political backlash if profits rose to a record share of GDP? I think a backlash is not unlikely.

Am I offering a scenario of doom and gloom? Hardly. The economy will, with its usual slumps and surges, continue to grow handily. Stock investors will continue to see earnings and dividends share in that economic growth (albeit with less than full participation from peak earnings levels). The main point is that investors’ expectations are probably too ebullient. Earnings will disappoint and double-digit stock market returns will not be the norm.

In a world of lower yields, slower earnings growth, and single-digit long-term stock market returns, we owe it to ourselves to examine three ideas in preparing for our own future. We – and our clients – should save more aggressively, to prepare a personal safety-net for ourselves. We should expect less from the stock market, which will not make up for anaemic savings with lofty returns. And we should look to diversify more broadly, outside of mainstream stocks and bonds, to mitigate out exposure to markets that may disappoint.


The writer is chairman of Research Affiliates and editor emeritus of Financial Analysts Journal. arnott@rallc.com

Copyright The Financial Times Limited 2017. All rights reserved.
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