Dr. David Kass – Why U.S. Equities Are Likely To Continue Rising To New HighsDr. David Kass
(1) The outlook for U.S. equities is very bright.
(2) Interest rates are likely to remain at historically low levels after several gradual increases in the Federal Funds rate in 2018 and 2019.
(3) Corporate profits will continue to grow at a rapid rate as a result of the Tax Cut and Jobs Act of 2017 and a GDP projected to grow at 2.5%-3.0%.
(4) Inflation is stable at 2%, matching the target of the Federal Reserve.
At the Berkshire Hathaway annual meeting on May 5, Warren Buffett mentioned that at age 11 he bought his first shares of stock on March 11, 1942 (three shares of Cities Service Preferred at $38 per share) during World War II. He then added that if someone had invested $10,000 in the S&P 500 Index on that date, it would now be worth $51,000,000 (compounded annual return of 12%). By contrast, a $10,000 investment in gold (a nonproductive asset) would be worth only $400,000 (compounded annual rate of return of 5%).
The economy today is in excellent shape and firing on all cylinders. Unemployment is at 3.8%, an 18-year low. GDP is projected to grow at a strong 2.5% – 3%. Inflation is at 2%, which is the target of the Federal Reserve.
The primary determinants of stock prices are interest rates and corporate profits. I will discuss the important role interest rates have played in the direction and level of stock prices over the past 53 years along with the impact of the recent reduction in corporate income taxes and finally compare the valuation of today’s stock prices to that of previous decades.
From the attached slide, “Berkshire’s Performance vs. the S&P 500”, I will refer to the last column only, “Annual Percentage Change in S&P 500 with Dividends Included” for each year from 1965 through 2017.
From this slide, the compounded annual gain over this 53 year period is 9.9%. In only 10 of the 53 years did the S&P 500 decline (19% of the years). On only one occasion, has the market declined by three years in a row (2000-2 – dot com bubble). Furthermore, the market has declined on only one other occasion by two years in a row (1973-4 – oil embargo, Middle East war, price of oil quadrupled).
On only one occasion did the S&P 500 decline by at least 30% (37% decline in 2008 – The Great Recession and Financial Crisis). The market has declined on only two other occasions by at least 20% (26.4% in 1974 and 22.1% in 2002). By contrast, the S&P 500 rose by at least 30% on nine occasions, plus it rose by at least 20% in nine other years.
Each of the recessions, except for the Great Recession of 2008, since World War II were preceded by the Federal Reserve sharply increasing the Federal Funds rate from much higher levels than today. The Great Recession of 2008 (Financial Crisis) was a result of subprime mortgages, an excessive amount of debt in the housing market, and the collapse of this market. Stock prices declined during these recessions.
Currently, the Federal Funds rate of 1.50 – 1.75% is at near historical lows. It is very likely that this rate will be increased gradually, by 0.25%, two or three more times in 2018, and perhaps two or three more times in 2019. The Federal Open Market Committee’s “Dot Plot” from March, 2018, indicates that the monetary tightening during this cycle likely would conclude with a Federal Funds rate of 2.75% – 3.00%. Since World War II, previous recessions have occurred at substantially higher Federal Funds rates. For example, the Federal Funds rate was increased from 4.44% in 1972 to 8.74% in 1973 and 10.51% in 1974. With Paul Volcker as Chairman of the Federal Reserve in 1979, the Federal Funds rate was increased from 7.94% in 1978, to 11.20% in 1979, to 13.35% in 1980, and to 16.39% in 1981. The Federal Funds rate was also increased from 4.97% in 1999 to 6.24% in 2000.
The Tax Cut and Jobs Act of 2017 reduced the statutory tax rate for corporations from 35% to 21%. Thus, corporations can now keep 79% of their pre-tax income vs. only 65% before. This 14% increase in the share of pre-tax profits that companies can now retain, represents an increase of 21.5% in their after-tax profits at the statutory level. After-tax corporate profits have also been growing at an 8.3% rate since 1970. Deregulation should further boost profits. Much of the additional profits have been, and will continue to be, used to buy back shares which should lead to higher prices.
In terms of valuation, the price to earnings ratio (P/E) of the S&P 500 is about 24 (trailing twelve months). Although this is relatively high as compared to recent decades, it is not as high as it reached in 2000. However, since interest rates are at near historical low levels, one would expect that stock prices (and P/E ratios) should be higher and, therefore, are not overvalued. Warren Buffett has said “interest rates are to stocks, what gravity is to matter”. Economic theory implies that low interest rates and an easy monetary policy can increase the demand for output. Furthermore, with 10 year or 30 year Treasuries currently yielding about 3%, they are selling for 33 times earnings and they do not have any growth as compared to stocks with likely growth in earnings.
In conclusion, with low interest rates that are likely to gradually increase to relatively low levels, corporate profits likely to grow at a healthy pace, inflation that is stable at the Federal Reserve’s target, and the stock market not being overvalued, the outlook for stocks remains bright.
Warren Buffett has stated that when he is no longer here, his wife should invest 90% of her financial assets in a low-cost S&P 500 Index fund (such as that offered by Vanguard), and the remaining 10% in short term Treasuries to cover any need she may have for liquidity.
Article by Dr. David Kass