On Earnings Growth and Stock Market Cycles and the China Study – Part VI!

From: Aditya Rana
Date: Sat, Nov 17, 2012 at 2:42 PM
Subject: On Earnings Growth and Stock Market Cycles and the China Study – Part VI!

Hi!,

With the current focus on slowing earnings growth, it is helpful to look closer at the historical relationship between earnings growth and stock market performance. Contrary to popular opinion, periods of high earnings growth do not necessarily imply superior stock market performance, and vice-versa, periods of sideways earnings growth can result in surging stock markets. An interesting note by James Paulson, Chief Investment Strategist for the money manager Wells Capital Management (AUM of $331 billion) helps shed light on this conundrum by demonstrating that there is a relationship between these two factors, but with a notable time lag effect. To summarise:

-The post-war US stock market has moved in a recurring three-step cycle (see chart below): 1) Earnings Production – during which earnings per share surge but stock prices trend sideways, 2) Getting Paid – a valuation driven period during which investors are paid via a surging stock market for the earnings produced during the previous period, even though earnings per share move sideways, and, 3) Traditional Run – a stage during which earnings and the stock market move up in conjunction – i.e. a traditional earnings driven stock market.

1)Post-War Cycle # 1 (1945-1970):

-Earnings per share nearly tripled from 1945 until 1950 during the “earnings production” phase of this cycle, after being flat for the previous 15 years (1930 until mid 1940s). However, the stock market was flat as confidence was low in the aftermath of the Great Depression and WWII, and this factor coupled with high post-war inflation, led to a lowering of P/E multiples.

-The next “getting paid” phase of this cycle lasted from 1951 until 1961, with the stock market rising 3.5 times even though earnings remained flat, as rising confidence allowed investors to get paid for earnings produced during the previous period (1940s).

-Finally, the first post-war cycle ended in a “traditional run” from the early 1960s until 1970 with the stock market following earnings higher, both rising by the about the same amount.

2)Post-War Cycle #2 (1970-2000):

Earnings per share once again tripled from 1970 until 1982 in this “earnings production” phase, while the stock market remained essentially flat, with P/E multiples being cut by two-thirds during this period of high inflation and rising bond yields.

-The “getting paid” phase lasted from 1982 until 1994, when the stock market surged almost four times and earnings largely trended sideways. This was a benign period marked by declining inflation and bond yields, and P/E multiples rose from 8 times in 1982 to 22 times in early 1994.

-During the last “traditional run” phase of the second post-war cycle, lasting from mid 1994 until the peak in 2000, the stock market rose 3.2 times and earnings rose 2.5 times. While P/E ratios continued to climb during this period, the stock market rise was mainly driven by the technology-driven boom in earnings.

3)Post-War Cycle # 3 (2000 to ???):

-The first phase of the current cycle began in 2000, with earnings doubling from 2000 until today but the stock market essentially trending sideways. While earnings growth was less than during similar phases of the first two post-war cycles, earnings growth then were boosted by higher inflation rates than currently prevailing.

The open question is whether the “earnings production” phase of the current cycle ends now and the “getting paid” phase begins, leading to a bullish phase in the stock market.

-While the driving force behind the 1980s-1990s stock market bull run was declining interest rates, which is unlikely to be a factor today given the currently low levels of yields, the current period could bear more similarity to the 1950s-1960s period of rising confidence in the aftermath of the Great Depression and WW11. The stock market rose during this period despite rising interest rates.

-The next two stages may depart from the character of the last two cycles, given the risk of another financial crisis, a war or a period of escalating inflation, but if the cycle does “rhyme” with the previous two it bodes well for the stock market.

-Assuming nominal GDP growth of 5% over the next 5 years (2.5% real and 2.5% inflation), and earnings growth of 4% (1% lower than GDP growth), share earnings would reach $122. So if inflation and rates remain subdued, P/E multiples could expand modestly to around 17 implying an S&P level of 2074 and a return for investors of 8.2% (10% if dividends are included).

Interesting perspective on stock market cycles, and an important lesson on not relying purely on correlation studies to form opinions on market behaviour! The analysis also sheds light on the puzzling lack of correlation between a country’s GDP growth and stock market performance as demonstrated by various studies – while from a statistical perspective there may not be a clear relationship, it ignores a host of other factors (the most important being valuations !) which could cause a lack of correlation! Earnings(GDP) growth is likely to eventually result in stock market performance, albeit with a lag. For the record, I think his projected 5 year returns for the S&P index are too optimistic, while we are currently in a QE induced cyclical bull market for the next few years, it’s likely to be derailed by an onset of higher inflation and rising interest rates during the second-half of this decade. A secular bull market is likely to ensue subsequent to that period!

The above analysis is one of the reasons (the other being record low valuations and supportive regulatory changes) why I expect the Chinese stock market to be one of the best performing major stocks markets in the world over the next few years – Chinese GDP has compounded annually by about 15% nominally over the last decade, while its stock market has been essentially flat. During the previous decade (1990s) , its stock market compounded annually by about 35%(!) while the GDP rose by roughly 15% per annum. For the coming decade, GDP growth is likely to be lower at about 10% (nominal), while its stock market could enter a “getting paid” period with significantly higher performance.

To illustrate this common fallacy, I summarise an interesting comment by the economist Nick Rowe on the well-known Milton Friedman’s thermostat problem:

“Everybody knows that if you press down on the gas pedal the car goes faster, other things equal, right? And everybody knows that if a car is going uphill the car goes slower, other things equal, right?

But suppose you were someone who didn’t know those two things. And you were a passenger in a car watching the driver trying to keep a constant speed on a hilly road. You would see the gas pedal going up and down. You would see the car going downhill and uphill. But if the driver were skilled, and the car powerful enough, you would see the speed stay constant.

So, if you were simply looking at this particular "data generating process", you could easily conclude: "Look! The position of the gas pedal has no effect on the speed!"; and "Look! Whether the car is going uphill or downhill has no effect on the speed!"; and "All you guys who think that gas pedals and hills affect speed are wrong!"…

If the driver is doing his job right, and correctly adjusting the gas pedal to the hills, you should find zero correlation between gas pedal and speed, and zero correlation between hills and speed. Any fluctuations in speed should be uncorrelated with anything the driver can see. They are the driver’s forecast errors, because he can’t see gusts of headwinds coming. And if you do find a correlation between gas pedal and speed, that correlation could go either way. A driver who over-estimates the power of his engine, or who under-estimates the effects of hills, will create a correlation between gas pedal and speed with the "wrong" sign. He presses the gas pedal down going uphill, but not enough, and the speed drops.”

The China Study – Part VI (Professor Colin Campbell):

Last week I provided the first part of the conclusions to the landmark China Study jointly conducted by Cornell , Oxford, and the Chinese Academy of Medical Sciences, and this week I summarise the second part:

Fat Consumption and diseases like breast cancer: There is a general misconception about the association between isolated aspects of fat consumption and diseases, which ignores the fact that it’s more important to consider how these chemicals act as a network rather than isolated single chemicals.

On average, we consume 35-40% of our total calories as fat, with dietary recommendations suggest cutting intake to 30% of calories. However, what is ignored is that animal-based foods contain more fat than plant-based foods and dietary fat is an indicator of how much animal protein is in the diet.

-Studies have shown an impressive relationship between dietary fat and breast cancer, with people who migrated from one region to another and started eating the typical diet of the region, assumed the disease risk of the area to which they moved. Studies have also suggested that genes are not necessarily important and only 2-3% of all cancers could be attributed to genes.

-However, this not imply that cutting down fat content will reduce the risk of breast cancer, as other studies demonstrate clearly that breast cancer risk is associated with the consumption of animal fat rather than plant fat.

-In rural China, fat was only 14.5% of the daily caloric intake, and was dependent mainly on the animal food content in the diet. Higher fat intake was also associated with higher blood cholesterol and female hormone levels, and reducing the fat intake significantly lowered the risk of breast cancer.

Importance of Fibre:-Based on the landmark study done in Africa on the consumption of dietary fibre and prevention of a variety of diseases, fibre seems to act by pulling water from the body and flushing out waster product and carcinogenic chemicals from the body.

-Dietary fibre intake in rural China (33g) is 3 times higher than dietary fibre intake in the US (11g). In addition, the higher fibre intake in China was associated with higher iron levels which was contrary to the prevailing view that high fibre intake reduces iron levels. The daily iron intake in China was about twice the levels in the US, and was primarily through the intake of plant-based foods.

-The China study demonstrated that high fibre intake was consistently associated with lower rates of cancers of the rectum and colon and lower blood cholesterol levels, which as mentioned previously, is associated with a lower risk of a variety of chronic diseases.

To be continued next week with the final conclusions!

Here is to eating more fibre (soluble and insoluble) in your diet through whole grains, plats and fruits!

Regards

Aditya

EMPUpdate31612.pdf

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