This post is excerpted from Probable Outcomes: Secular Stock Market Insights by Ed Easterling, released January 14, 2011.
Earnings growth is a major driver of stock market returns and business valuations. The most significant driver of earnings growth over time is economic growth, measured as gross domestic product (GDP).
Economic growth, relatively stable for decades, veered in the most recent decade of the 2000s. This excerpt from chapter 3 of Probable Outcomes highlights an unconventional insight that refutes a conventional misunderstanding.
Before venturing further into the discussion about the P/E cycle, pause a moment for a pop quiz to highlight the previous point about the effect of economic growth on P/E. There is new information that could actually make it different this time!
Beyond the insights from the question and its answer, this will start the journey toward the potential scenarios for the economy over this decade and the implications for stock market returns.
Over the past century in the United States, real economic growth before inflation has averaged near 3% per year. Over the decades of the 1970s, 1980s, and 1990s, the compounded average annual growth rate was 3.2%, 3.0%, and 3.2% respectively.
So during the decade of the 2000s (2000–2009), when consumers were loading up their credit cards, homeowners were said to be using home equity like an ATM, unemployment averaged 5.5% and fell below 4% at times,and leverage was being added to leverage, what was the compounded annual growth rate before inflation rounded to the nearest per cent?
The first choice, 4%, is the most logical response. It reflects the perception that much of the consumption and leverage artificially accelerated economic growth. People that choose 4% expect that the factors in the question boosted economic growth above the historical and recent average growth rate.
Following such a strong period of economic growth, most people answering “A” expect a period of below-average growth over the 2010s to make up for the excesses of the prior decade. They expect that periods during which growth was fuelled by debt will be followed by offsetting moderation as the vestiges of leverage and excess consumption are addressed.
The second choice, 3%, is the contrarian response. It reflects a belief that this time was not different. Though some of the factors included in the question may have impacted economic growth, people who choose 3% either don’t believe that those factors had much effect, or presume that there may have been similarly unique factors during prior decades.
Nonetheless,economic growth of 3% has endured for more than one hundred years and has been very consistent in recent decades. Some people in this group believe that 3% is likely for this decade, while others have begun to adopt the notion of a New Normal with slowing growth due to recent trends in demographics, government policy, taxes, etc.
The third choice, 2%, is the correct response, despite being least selected. Many investors are surprised that the decade of the 2000s experienced compounded annual growth of only 1.9%.Some economists say that it was a decade sandwiched by two recessions, while others blame it on the severe recession of 2008 and the related financial crisis.
Yet excluding the recession of 2008 from the decade, the growth rate for the first eight years of the 2000s was still only 2.6%. Further, cumulative economic growth throughout the decade of the 2000s did not exceed 2.7%. It would have required an unusual surge—near 4.5% annually—in the final two years for the full decade to reach the historical average annual growth rate of near 3%.
This sets the stage for a dilemma. Will the decade of the 2010s restore the long-term average by growing at 4%, thereby defying the predominant belief of a slow-growth decade? Was the prior decade of the 2000s an anomaly, with future economic growth simply returning again to its long-term trend of 3%?
Did something change 10 years ago, and has economic growth downshifted to a level near 2%, or as some might contend, could the rate be even lower due to the economic,financial, and/or policy headwinds in front of us? All three scenarios are plausible, which makes economic growth Major Uncertainty #1. The answer to the dilemma has very significant implications for stock market returns over this decade and longer.
Excerpted from Probable Outcomes: Secular Stock Market Insights by Ed Easterling, Copyright © 2011. Excerpted with permission.
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