Market Shifts: Exploring the Upcoming Stages in Stock Markets
Recent evidence suggests that investors may expect lower Internal Rate of Returns (IRRs) in the S&P 500 over the next 10-20 years. This prediction is supported by the sustained levels of the Cyclically Adjusted Price-to-Earnings (CAPE) Ratios, which have reached above 30, a phenomenon last observed during the Great Depression and the dotcom bubble.
The analysis considers two measures: Corporate Profits After Tax with Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj) ("CPATAX"), and Corporate Profits After Tax (without IVA and CCAdj) ("CP").
The relationship between these corporate earnings measures and the S&P 500 is strong, as demonstrated by two charts. The ratio of CP or CPATAX to the S&P 500 initiates a bullish trend when it reaches a value of 0, signifying a favourable earnings environment. Conversely, a value of negative -0.6 indicates the start of a consolidation phase, where earnings may be stagnant or even decline.
Historically, consolidation phases have lasted 10-20 years and have been associated with muted to potentially negative IRRs in the S&P 500. As such, institutions should consider favouring investments and strategies that offer yield, steady cash flows, or rely on low-correlation, relative-value, and alternative betas, which provide growth-like returns but are not dependent on the same systemic factors as equity markets.
Investors should prepare for a potential period of stagnant, sideways markets as the earnings/market cycle resets. Over the near- to medium-term horizon, markets may experience significant advances, but the overall thesis presented here is that the current earnings/market cycle is stretched and will look to reset over a significant period of time.
Experts like Jim Paulsen have indicated that corporate profits have been below post-war trendline averages for about a decade, suggesting potential room for profit growth and market gains in the future. By monitoring profit cycles, investors can anticipate equity market phases and adjust their portfolios accordingly.
While timing these adjustments perfectly is challenging, ignoring fundamental earnings signals may expose investors to valuation risks or missed opportunities. Institutional and forward-looking indicators, including revenue growth, sector performance, and other factors, can further inform these decisions.
It is important to note that the rationale for making the IVA and CCAdj adjustments is not debated in this analysis. The St. Louis Fed and the Bureau of Economic Activity publish data on corporate earnings growth dating back to 1947, providing a wealth of historical evidence to support these findings.
In conclusion, the historical pattern indicates that equity market returns broadly track corporate profitability over the long run, and investors often use earnings trends as a barometer to adjust equity exposure. By staying attuned to these trends and making strategic portfolio adjustments, investors may be better positioned to navigate potential periods of low equity returns.
- Given the prediction of lower Internal Rate of Returns (IRRs) in the S&P 500, investors might consider favoring investments and strategies that offer yield, steady cash flows, or rely on low-correlation, relative-value, and alternative betas, as these provide growth-like returns but are not dependent on the same systemic factors as the stock-market.
- To navigate potential periods of low equity returns, investors should monitor profit cycles, such as those shown by Corporate Profits After Tax with Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj) ("CPATAX"), and Corporate Profits After Tax (without IVA and CCAdj) ("CP"), which often serve as a barometer to adjust equity exposure and stay attuned to earnings trends in the finance industry.
