With Social Security reform in the air and the election behind us, all eyes are on the stock market: Will it rise or fall as 2005 unfolds? For one perspective, we can look at what most of the big-name gurus are saying:
- Jim Rogers is very bullish on commodity prices and bearish on stocks ? despite the fact that the demographic and technological trends say the stock market is about to enter one of the greatest bull markets in history, and commodity prices will likely slow or even fall due to rising productivity.1 - Warren Buffett sees unending weakness in the U.S. dollar ? just as we expect to start seeing a resurging economy propel the next substantial rise in the dollar.2 - Jeremy Siegel’s new book3 is trumpeting value stocks, which do perform better over the long haul ? just as we are entering another one of those periods when growth stocks will again strongly outperform value stocks.4 But as we know from history, most of the highly regarded economic experts tend to be wrong at key “turning points.”
At moments like these, you need to look at the fair market value of the underlying assets to get an idea of where the markets are going. That’s why, even as interest rates begin to move up from their record-setting low levels, and the corporate productivity explosion reaches equilibrium, bringing new jobs on line, we can still rely on the most important item of all ? capitalized corporate earnings ? to remain a sound indicator of what’s to come.
As Lawrence Kudlow and John Park pointed out in multiple commentaries during the month of December, doing the math will show the way. And it’s not that hard. Profits are defined as sales volume times the margin. Using monthly economic data on manufacturing, wholesale, and retail business, you can easily calculate volume. And by taking the ratio of output price to unit labor cost, you can find the margin.5
This creates a proxy that has reliably tracked profit since 1980. Moreover, business sales growth and nominal GDP run in close parallel, a correlation of about 0.74 over the last 25 years.
In their December 15, 2004 commentary, and elsewhere, Kudlow and Park predicted 6.5 percent nominal GDP growth in 2005, which translates into 10 percent growth in business sales, slightly less than the 11 percent annualized growth we were seeing at the end of 2004. So that gives a fair indication of aggregate sales volume for 2005.
Measuring margin, we get an annual rate of 1.6 percent growth, which has been the mean average margin growth rate since the recession ended in 2001. Realistically, that could slow to just 1 percent this year, which would translate into a growth in non-financial profits in 2005 of 11 percent. That would be a 10 percent profit growth due to higher sales volume, plus 1 percent profit growth due to enhanced margins.
The low point for non-financial profits occurred in 2001, at $7.1 trillion. As the recession ended, non-financial profits rose in the next three years to reach an estimated $15.1 trillion in 2004. At the slightly slower rate of 11 percent profit growth expected for 2005, and assuming a 5 percent yield for the 10-year Treasury note, capitalized profit for 2005 should be $14.2 trillion.
What does all that mean? It means that between the bottom in 2001 and the projected figures for 2005 there will have been a rise in capitalized profits of about 100 percent. But a broad stock market price metric, represented by the Wilshire 5000, shows only a 61 percent rise from the bottom in late 2002 through year-end 2004. In short: Stocks have a lot of room to move upward.
Using the Moody’s BAA corporate rate to capitalized profits paints an even more compelling picture. Doing the calculations, you get a 121 percent rise in capitalized profits from 2001 through 2005 and a bigger lag in stock prices.
Another way to look at stock market valuation is to compare it with bonds, and it yields the same answer.6 A simple calculation based on the First Call analyst survey shows the S&P 500 forward P/E ratio to be 16.9 percent. That translates into a 5.92 percent earnings yield. The forward 10-year Treasury yield is 4.49 percent. That suggests that stocks are undervalued by 24 percent, at a minimum.
Comparing real after-tax yields on stocks versus bonds gives an even bigger upside. If you assume a 35 percent tax rate and 2.5 percent inflation, you can calculate a real after-tax earnings yield for the S&P 500 of 1.35 percent. Compare that with the after-tax Treasury yield of 0.42 percent, and you get a 70 percent under-valuation of stocks going into 2005.
While we’re not suggesting that the market is going to jump 70 percent this year, there is no reason in any of the data that suggests it could not experience a very healthy rally. Social Security reform can be expected to move large amounts of money into the market, perhaps as early as this year, giving momentum to such a rally. Tax code reform will broaden the tax base, and eliminate a lot of the confusion.
If the 50 percent cash-expensing bonus for business capital investment is renewed, that will add fuel to the fire. More investors, in turn, will pour more money into the market in pursuit of higher returns.
Those higher returns are already in the wind and do not require any fancy calculations to see. The fourth quarter of 2004 was strong enough to signal what’s ahead. Real consumer spending is growing by almost 4 percent with low inflation. Core consumer prices are increasing by a mere 1.4 percent.7
Even more significant is the continued rise in capital spending on equipment during the past year. During 2004, we saw it rise by 11 percent. Even manufacturing has started to boom, with shipments for machinery and primary metals up 17.3 percent and 32.6 percent, respectively, in 2004. The after-tax return on stockholder equity for the manufacturing sector was nearly 16 percent in the third quarter. This is significant when you remember that in the first quarter of 2001 the ROE was zero, while the six-year average for the period ending in 2000 was 16.1 percent, almost exactly where it is today.
Finally, we can get a good idea of the outlook for stocks by taking a look at the health of the recovery. The overall economic health of the nation is best measured by looking at core domestic growth. That means subtracting inventories and foreign trade from the regular gross domestic product numbers. By that measure, the economy grew by 5.7 percent in 2004. Again, the capital spending explosion now taking place is powering this growth and putting business on a firm footing to take advantage of increased consumer demand. Those increases in consumer demand, in turn, will rise as new jobs are added at a rate of about 200,000 a month in the period just ahead, as we approach the historical peak for non-farm payroll levels last seen in 2001.
What does this all mean? Based on the valuation trend, as well the broader economic trends, we offer the following five forecasts for your consideration:
First, this is all part of a larger picture of economic health that will continue not only through the year, but through the balance of the decade as well. The Dow has already shot through the 10,800 level, shattering the old barriers of the last few years. After a brief pullback, we expect it to head to 2000 record levels in the coming months and surge beyond that in the coming years.
Second, corporate profits will continue to climb, pushing stock prices up. Revolutionary productivity gains surging at around 5.6 percent, profits rising in double digits, and labor costs dropping at a 0.1 percent rate, all add up to continued capital expenditure, hiring, and profit growth.
Third, as baby boomers reach their spending peak, and the information technology infrastructure buildout continues throughout the global economy, companies will see more and more of their earnings dropping to the bottom line. With more people employed, there will be more consumer spending. These trends will translate directly into climbing stock prices.
Fourth, the general public will increasingly return to mass investing in 2005 and beyond. A series of administration policies, from tax cuts to Social Security reform, will make the stock market irresistible to individual investors. That will only push prices upward, driving several years of high returns for shareholders.
Fifth, all this leads us to one undeniable conclusion: A lot of people are already making a lot of money, and they’re going to make a lot more over the rest of the decade. This is a clear signal that shifting funds back into equities is a smart move for 2005.
References List : 1. Fortune, December 13, 2004, “Its the End of the World as We Know It, and He Feels Fine,” by Brian OKeefe. ⓒ Copyright 2004 by Time, Inc. All rights reserved.2. BostonHerald.com, January 19, 2005, “Buffet Says Dollar to Decline Further Amid Trade Gap.” ⓒ Copyright 2005 The Boston Herald. All rights reserved.3. The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New by Jeremy J. Siegel is published by Crown Business, a division of Random House, Inc. ⓒ Copyright 2005 by Jeremy J. Siegel. All rights reserved.4. Fortune, December 13, 2004, “The Growth Trap,” by Jeremy Siegel. ⓒ Copyright 2004 by Time, Inc. All rights reserved.5. To access Lawrence Kudlow and John Parks’ commentary on using capitalized profits to forecast stock potential, visit the American Skandia website at: www.americanskandia.prudential.com/media/managed/documents/ams_investor/comm121504.pdf6. To access Lawrence Kudlow and John Parks commentary on undervalued stocks, visit the American Skandia website at: www.americanskandia.prudential.com/media/managed/documents/ams_investor/com122204.pdf7. To access Lawrence Kudlows commentary on capital spending on equipment, visit the Kudlow & Company website at: www.kudlow.com
