Do the impressive returns in public and private markets stem from strategic financial engineering or reflect actual economic growth?
Topics covered include:
- How corporate profit growth is linked to economic growth, even though corporate profits are more volatile
- How interest rates, tax rates, and stock buybacks influence corporate profits and stock returns
- Why there are fewer publicly traded stocks
- How the increase in leveraged buyouts has impacted the economy
- How private equity funds use financial engineering to boost returns
Show Notes
US CEOs start to contemplate Trump, round 2 by Rana Foroohar—The Financial Times
10-Year Stock Market Returns—Crestmont Research
Stock Average—Crestmont Research
Stock EPS Reality—Crestmont Research
Nominal Gross Domestic Product for United States—FRED Economic Data
The Secretive Industry Devouring the U.S. Economy by Rogé Karma—The Atlantic
Key Drivers Behind Widespread Adoption Of NAV Financing by Matthew K Kerfoot—Proskauer
The Inevitable Rise of NAV Financing by Patricia Teixeira and Anastasia Kaup—Ropes & Gray
LBOs Make (More) Companies Go Bankrupt, Research Shows by Alicia McElhaney—Institutional Investor
Leveraged buyouts and financial distress by Brian Ayash and Mahdi Rastad—ScienceDirect
Episode Sponsors
NetSuite – Get your free KPI checklists
LinkedIn Jobs – Use this link to post your job for free on LinkedIn Jobs
Become a Better Investor With Our Investing Checklist
Become a Better Investor With Our Investing Checklist
Master successful investing with our Checklist and get expert weekly insights to help you build your wealth with confidence.
Related Episodes
219: The Incredible Shrinking Stock Market
298: The Stock Market Is Not the Economy
Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 458. It’s titled “Dissecting Stock Returns: Financial Engineering or Genuine Growth?”
Financialization of Growth
I recently read an article by columnist and associate editor of the Financial Times Rana Foroohar. She used a phrase I hadn’t seen before, financialized growth. We’ve discussed financialization in the past, which is the increasing role of financial motives, and markets financial actors and institutions in domestic in international economies. That’s from a definitions from Gerald Epstein. But I hadn’t really put that word, “financialization”, with the word “growth”.
Foroohar referenced a paper that came out last summer by principal economist at the Federal Reserve, Michael Smolyansky. The paper is titled “The End of an Era. The Coming Long-Run Slowdown in Corporate Profit Growth and Stock Returns.” He’s predicting stock returns are going to be lower because the returns were boosted by an element of financialization; namely, lower tax rates and lower interest rates. And we’ll take a look to see, is that financialized growth, if the growth, in this case corporate profits, was due to lower interest rates, or lower tax rates?
What Drove Stock Returns
In the paper, Smolyansky writes: “From 1989 to 2019 the S&P 500 index grew at an impressive real rate of 5.5%per year, excluding dividends.” During the same period, the US economy grew at a real GDP growth rate—GDP being in the measure of the value, of the output produced—it grew at 2.5% per year.
And in reading this and going through the analysis, I misinterpreted what the author said. I thought he said corporate profits grew at 5.5% per year, while the economy grew at 2.5%. It turns out that 5.5% was the price appreciation of the index, which was driven by corporate profits, which grew at 3.8% per year on a real basis. That does mean that corporate profits grew faster than the economy. That’s not normal. It’s unusual.
Generally speaking, corporate earnings, either on a nominal basis or a real basis, grow at the same rate of the economy. And I went to one of my favorite sources to confirm some of this data. It’s Crestmont Research, founded by Ed Easterling. He has some fantastic charts on many aspects of the stock market.
In fact, Crestmont has a beautiful chart that shows the drivers of stock returns that we use on Money for the Rest of Us, that we use in Asset Camp, namely dividend yield, earnings growth, and the change in valuation. And they do this stacked bar chart that I’ll link to in the notes, that shows how much of a decade’s worth of return was driven by those three factors.
And we’ll see over the past three or four years, the 10-year returns, that most of the appreciation in the US stock market has been driven by the change in valuation, stocks getting more expensive. We do show that historical attribution on Asset Camp, but it was fun to see it in this bar chart format, to see “Wow, in neon green, the expansion in the P/E really elevates the return.”
So I looked at Crestmont Research, and he had an interesting statistic. This is through the end of 2022, since 1950. It’s a 73-year period. Every year, except 2009 and 2020, it’s a positive nominal growth in the economy. This is before backing out inflation. Typically, when GDP is quoted, it’s quoted net of inflation, so on a real basis. And we can have a negative real GDP growth, but once inflation is added back, it could be positive.
As a Money For the Rest of Us Plus member, you are able to listen to the podcast in an ad-free format and have access to the written transcript for each week’s episode. For listeners with hearing or other impairments that would like access to transcripts please send an email to team@moneyfortherestofus.com Learn More About Plus Membership »
