Growth expectations are higher, but are they justified?

The Mill Street Research Implied Growth Model, described in more detail in a March post, shows higher long-run earnings growth expectations built into market prices. Given current conditions and the composition of the S&P 500, this may be justified, but means growth concerns will continue to dominate inflation or other worries for stock prices.

Long-run growth expectations are higher, but what is “fair” nowadays?

The earlier post describes the model I use to estimate the level of long-run real (inflation-adjusted) earnings growth that is being priced into stock prices. The latest readings from that Implied Growth Model are now back at the high end of the range over the last 15 years, currently around 3.3% (green line in chart below). They are, however, far below the historic extremes reached around the “bubble” in 1999/2000 near 8%, and have come off very low (briefly negative) readings after COVID hit.

Source: Mill Street Research, Factset, Bloomberg

Two questions naturally arise from a model estimate like this:

• Do we agree with the model’s inputs and assume it is a reasonable estimate of what market participants expect?
• Assuming the answer to the first question is yes, do we think that the result is a reasonable growth rate to assume, i.e., is the market overly optimistic, pessimistic, or about right?

Any model is necessarily a simplification of reality, and brings explicit and implicit assumptions. While I believe that the logic of the model makes sense and has been useful historically, it is always worth checking the assumptions.

Source: Mill Street Research, Factset, Bloomberg

While some of the model inputs are market prices (S&P 500 index and current Baa-rated corporate bond yields), others are necessarily assumptions based on known historical data. One of them, for instance, is the estimate of the risk premium (additional expected return) that investors require in return for owning riskier stocks rather than corporate bonds (corporate bonds have their own time-varying risk premium built in relative to default-risk-free Treasuries). In this model, that risk premium ranges from 2% to 4% based on the growth rate of the US Leading Economic Indicators (LEIs). Weak or negative LEI growth suggests investors are worried about the economy and demand higher returns from equities to compensate, while high LEI growth (a strong economy) would require less of a risk premium to own equities.

The model’s current risk premium is still relatively high at 3.57%, due to the unusually weak (negative) readings of the LEIs for some time now. However, the LEIs have turned out to be wrong (or extremely early) this cycle, as they have been forecasting recession since 2022 and it still hasn’t happened yet. That doesn’t mean investors have not worried about recession (the news reports in 2023, and even earlier this year, clearly suggest that they have), but the elevated risk premium makes the current implied growth reading higher than it might otherwise be in light of the US economy’s unexpected strength.

A similar case can be made for the normalized, or mid-cycle, estimated S&P 500 earnings (EPS). The current figure of $170 is based on the 10-year average of EPS for the S&P 500 and then adjusted for inflation to current dollars. This is done to remove the cyclical swings in earnings and avoid pricing stocks based on peak or trough earnings. However, the current $170 reading is well below the expected 2024 EPS for the index of about $235, so for earnings to average anywhere near $170 over the next 10 years would require a sharp and sustained drop in earnings that would be extremely unusual historically. Thus the earnings input is also making the implied growth reading look higher than it otherwise might.

Source: Mill Street Research, Factset, Bloomberg

Is the model’s estimate of 3.3% long-run real EPS growth high?

As we noted before, one can base a view of what is “fair” for the long-run growth assumptions on various things. One would be the view that profits should grow in line with the overall economy over the long-run, so an estimate of long-run US real GDP growth would be a starting point for long-run real earnings growth. Historically the US real GDP growth rate has averaged around 2.5%, and some projections suggest it will be a bit slower than that as population growth slows and the population ages.

To gauge it more directly, however, we can look at the actual historical real growth rate of S&P 500 operating EPS, shown in the chart below using a rolling 20-year trendline growth rate. The historical real growth rate has been around 4% in the last 30 years (and not slowing down), though lower in periods before that (1970s and early 1980s were much weaker).

Source: Mill Street Research, Standard & Poor’s

So today’s 3.3% reading from the model for implied future long-run real earnings growth is actually still somewhat below the growth rate seen in the last 20-30 years, though perhaps closer to the very long-run average, and slightly above the growth rate of US real GDP. One can certainly argue that corporate earnings can grow faster than GDP due to the differing composition and the fact that large US companies do business globally. This is especially true given the higher growth and higher profit margins over the last 10 years in the US Technology sector, which also captures global growth.

Of course, much depends on macroeconomic policies as well. In the 1970s and 1980s, one could argue that US monetary and fiscal policies were misguided, and the US and world were subject to multiple large shocks that impacted US corporate earnings (going off the gold standard, OPEC oil shocks, hot and cold wars, etc.). Such shock events have not stopped, with COVID, the war in Ukraine, and OPEC’s attempts to prop up oil prices being the modern examples. But US corporate profits have held up better than one might have expected, and better than in many other countries. Some of this can perhaps be attributed to better macro policy decisions, as well as the reduced sensitivity of the US economy to some kinds of global shocks (e.g. the US and other non-OPEC countries produce a lot more oil and gas now, giving OPEC far less control over global energy prices).

If one takes the last 30 year trend in real corporate profit growth and assumes it will continue, or even slow slightly, then our model’s implied growth readings are not excessive, but perhaps closer to fully valued. What does this mean? It suggests that stocks can continue to outperform bonds by a reasonable amount (the risk premium of ~3.5%) if earnings do in fact grow at a rate of at least 3.3% more than inflation. Signs that growth will be lower than that would potentially cause stocks to underperform bonds (or only marginally outperform).

So the bar for growth expectations is clearly higher now, as higher real bond yields mean that investors can get a moderately positive real return from safer bonds, and thus need continued economic and earnings growth to justify owning riskier stocks. This suggests that “bad news” for stock prices will come from signs of growth that is too weak, and not from concerns that growth will be “too strong” (i.e., inflation). Real (inflation-adjusted) growth is rarely actually “too strong”, as true capacity constraints on the economy only become visible in extreme situations like large-scale wars (WWII) or massive supply shocks like COVID. It is only the fear of policy makers mistakenly trying to slow the economy unnecessarily (due to unwarranted fears of inflation from even modest growth acceleration) that causes markets to get nervous when growth is strong.

Until growth actually slows, stocks can keep outperforming bonds

The message from the model is that while the bar is higher for earnings growth that will keep investors happy, so far the results from companies are still jumping over that bar, as is overall economic growth. And as the Fed lowers rates, the “hurdle rate” for future growth will gradually come down. With the model at elevated but not extreme levels and potentially conservative given its current inputs, I am less worried about stocks being extremely overvalued (as some commentators are), particularly given that policy interest rates are coming down.

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Originally Posted October 28, 2024 – Growth expectations are higher, but are they justified?

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