The separation of the stock market and the economy

This is how the rationale for supporting the “bull market” narrative is currently being presented. However, it is worth questioning the validity of this statement. During the economic standstill in 2020 and the subsequent market recovery, I formulated:

“A significant contrast between the almost depressed economy and the upswing on the stock markets is becoming clear,” was my formulation at the time. The question that arose was: can both be equally true?

Time passed and revealed what many market observers already suspected. The market, as the financial world often seems to dictate, was clearly rushing ahead of economic growth. Share prices reached dizzying heights while the real economy was still struggling with the after-effects of the pandemic. But 2022 was to serve as an instructive episode: Markets adjusted to economic realities and much of the gains previously made melted away.

Given the complex links between the economy, corporate profits and asset prices over time, this development is hardly surprising. A look at historical data since 1947, supplemented by the latest estimates for 2023, illustrates the close interdependence of these factors.

Since 1947, earnings per share (EPS) have recorded annual growth of 7.72 %, while the economy has grown by an average of 6.35 % annually. This close link between growth rates seems plausible if one considers the outstanding importance of consumer spending in the calculation of gross domestic product (GDP).

However, it is important to emphasize that the massive expansion of corporate profits as a result of stimulus measures could raise average EPS by more than one percentage point. In 2020, the average EPS growth in line with a normal expansion would have been 6.35 %, in line with the growth of the economy.

In addition, the long-term annual growth of the S&P 500 was significantly influenced by monetary policy interventions by the Federal Reserve (Fed). Before the Fed’s interventions, average long-term growth was around 8 %. After the Fed’s interventions, this average rose to over 9 %. This development is illustrated in the following chart.

After a decade, however, many investors developed a certain inertia and began to take high returns from the financial markets almost as a matter of course. In other words, the unusually high returns generated by substantial liquidity injections seemed to become almost the norm. As a result, it is not surprising that investors developed various explanations to legitimize the excessively high asset prices.

Other indicators of market exaggeration

When it comes to comprehensively assessing the market situation, corporate profits are an excellent indicator of economic strength.

The detachment of the stock market from underlying profitability does not bode well for investors in the future. Nevertheless, it has often been shown in the past that the markets can “remain irrational for longer than logic would suggest”.

Nevertheless, such decouplings are rarely of a long-term nature.

“Profit margins are probably one of the factors that most closely approximate the average, and if profit margins don’t reach that average, then something is wrong with the capitalist system and it’s not working properly.” – Jeremy Grantham

History shows us that profit margins tend to revert to the average, and a deviation from this pattern is usually only temporary. When looking at inflation-adjusted profit margins in relation to GDP, this trend becomes clear. This “mean reversion” often accompanies recessions, crises or bear markets.

This fact should come as no surprise, as asset prices should ultimately reflect the underlying reality of corporate profitability, which in turn is a consequence of economic activity.

Particularly significant is the fact that physical limits are imposed on corporate profits. Every dollar earned competes with expenditures such as infrastructure, research and development, wages and the like. The expansion of profit margins has been aided in particular by the suppression of employment, slowing wage growth and artificially low borrowing costs. In the next recession, a decline in consumption is likely to lead to a significant slump in corporate profitability.

Recessions cause a reversal of surpluses
The chart below illustrates the cumulative change in the S&P 500 index compared to corporate earnings. Again, it shows that these excessive surpluses are reversed when investors spend more than USD 1 for USD 1 in earnings.

The correlation is clearly evident from the relationship between market activity and corporate profits in relation to GDP. Given that corporate profits are ultimately an effect of economic growth, this link is of course to be expected. Therefore, the imminent reversal in both data sets should not come as a surprise.

Until now, there seemed to be a seemingly simple equation: as long as the Fed actively supported asset prices, the discrepancies between the fundamentals and the fantasies played virtually no role. This point of view is hard to refute.

However, what is not yet complete is the historical mean reversion process that traditionally follows bull markets. This should not really come as a surprise to anyone, as asset prices ultimately reflect the underlying reality of corporate profitability and economic growth.

A potential problem is that the continuation of post-financial crisis era returns is highly unlikely unless the Fed and the government continue their support through fiscal and monetary policy measures. Without this type of support, economic growth is likely to return to previous growth rates of below 2 % due to increased debt and deficits.

The chart below compares all monetary and fiscal interventions with economic growth. The disconnect between markets and fundamental economic activity over the past decade has been largely due to repeated monetary policy interventions that have told investors that “this time everything is different”. The chart below shows the cumulative interventions that have created the illusion of natural economic growth.

The prospect of reproducing USD 10 in interventions for just USD 1 in economic resources over the next ten years appears to be significantly lower. Of course, the burden on future earnings from the excessive debt accumulated in the wake of the financial crisis must also be taken into account. The sustainability of this debt is dependent on low interest rates, which can only be maintained in an environment of low growth and low inflation. A low level of inflation and slowing economic growth do not create conditions for excess returns.

Nevertheless, it is not uncommon for the market to decouple from underlying economic activity over longer periods of time, while speculative excesses distract the markets from fundamental realities. This is also illustrated by the following chart, which shows the stock market in relation to inflation-adjusted GDP. In all cases, the market surpluses eventually return to the average line. The only unknown is the trigger that sets this process in motion.

It seems hard to imagine that future returns will not be disappointing compared to the past decade. However, we should not be misled by building excessive returns on a monetary illusion. This could have unpleasant consequences for investors once this illusion is finally shattered.

Does this mean that investors will NOT make any profits in the next ten years? That is not the case. On the contrary, everything indicates that returns are likely to be considerably lower than in the last ten years.

Nevertheless, even an average return can be extremely disappointing for many.