Jonathan H. Todd: Falling earnings growth, through increased wages and investment, would likely make the market more expensive, but boost long-term potential.
By most measures, this market has gotten quite expensive. The Shiller P/E ratio, based on a cyclically-adjusted price to earnings ratio, shows the market being significantly overpriced, relative to this historical average.
As previously noted, the market P/E ratio can decline even without decrease in prices – for example, if earnings growth exceeds price growth. This time, however, let’s consider another possibility: what if earnings growth falls? In this case, there are two outcomes:
1) Market prices fall accordingly, which would mean investors are losing faith in companies long-term ability to drive earnings.
This isn’t out of the question, given the tenuous state of the economic recovery, and is a scenario touted by people like Gina Martin Adams of Wells Fargo, who has a 2014 year-end target of 1,850.
2) Market prices are stable, or rise, indicating that the falling margins are due to factors that will be healthy for companies in the long-run.
The second point is all about use of cash. Margin growth has come from companies not only squeezing costs by not hiring/not paying more/not investing, but also from the record stock buybacks that companies have engaged in recently. As a Bloomberg report recently noted,
About $535 billion has been spent on buybacks in the past four quarters, contributing about 2 percentage points of earnings growth to the S&P 500, according to Glionna. The report states that repurchases eat up more than 30 percent of cash flow, nearly twice the proportion in 2002, while capex has fallen to about 40 percent from more than 50 percent in the early 2000s, the report said.
The second scenario seems like the more likely outcome (at least to this observer). Companies have allocated so much to buybacks, and so little to capex, that they will at some point have to start investing if they want to continuing operating. That is, at some point, worker productivity will be maxed out, and capacity utilization will start to flatten, showing that investments in human and physical capital are needed.
Utilization has grown constantly since the recession, and is approaching 2000s pre-recession levels.
This week’s Real Output Per Hour figures showed only a 1.1% growth in worker productivity year-over-year, continuing a trend of recent slow productivity growth. And Capacity Utilization recently had its highest reading since June 2008, at 79.2%.