As 2Q13 earnings season approaches, we would focus on the overall EPS growth trend as a bellwether of stock market direction. We are slightly above-consensus with a forecast of mid-single-digit EPS growth in 2Q13. Anticipating easier comparisons against the pre-fiscal cliff quarters of the 2012 second half, we then look for low double-digit EPS growth in the back half of 2013. The historical record suggests that rising EPS growth correlates better than GDP growth with a rising stock trend.
Since Bernanke's infamous mid-June press conference, bonds have been routed. Despite the "new normal" of the 10-year Treasury yield at 2.7%, stocks are still standing, with over 70% trading above their 200-day moving averages. In a bit of "bad is good" reasoning, stocks rallied on the final revision in 1Q13 GDP to 1.8%, from a preliminary 2.4%, because the weakening GDP trend appeared to extend the life of quantitative easing. A few weeks later, however, stocks rallied on "good is good" news when the U.S. labor force added 195,000 workers in the June nonfarm payrolls report. We believe the stock market is getting used to rising bond yields amid increasing global economic activity.
We have demonstrated a tight link between equity market performance and S&P 500 earnings from continuing operations. U.S. GDP growth, meanwhile, seems less and less correlated to the pace of corporate earnings growth or to stock market performance.
Earnings growth rather than GDP growth lines up better with the stock market price trend. While that is true in general, it has been most notable during the market rally since March 2009. While U.S. GDP growth in the four years of the bull market has averaged about 1.75% annually, S&P 500 earnings growth from continuing operations has averaged about 15% in that period. And the compound annual growth rate [CAGR] in the S&P 500 between 2008 and 2012 was 12.1%.
The Historical Record
We decided to quantify the relationship between annual growth in U.S. Gross Domestic Product [GDP] and corporate profits. For GDP, we used percent change based on chained year 2000 dollars; for profits, we used S&P 500 earnings from continuing operations. We used our usual survey period of 1980 to the last full year, which is 2012. We looked at the overall relationship for this period, as well as across a range of shorter segments.
Between 1980 and 2012, U.S. gross domestic product growth based on chained year 2000 dollars averaged 2.64%. Between 1980 and 2012, S&P 500 earnings from continuing operations averaged annual growth of 7.4%. Thus, earnings grew at 2.8 times the pace of GDP growth.
Looking at some smaller segments of time, we see a gradual deterioration in U.S. GDP growth, perhaps reflecting the shift in global wealth toward emerging economies. Earnings growth, however, was initially barely impacted by this change. Subsequently, as U.S. multinationals became more leveraged to emerging economies, the ratio of earnings growth over U.S. GDP growth actually widened.
Between 1990 and 2012, U.S. GDP growth averaged 2.42%; S&P 500 earnings from continuing operations averaged 7.7% growth; and the ratio of earnings to GDP widened to 3.18-times. Between 2000 and 2012, U.S. GDP growth averaged 1.73%; S&P 500 earnings from continuing operations averaged 7.2% growth; and the ratio of earnings to GDP widened to 4.15-times.
The bull market that began in March 2009 has coincided with growth in global trade; tremendous emerging economy growth and increasing reliance on that growth for S&P 500 profits; and decimation of the U.S. contribution to EPS growth in 2008-09, from which the U.S. economy is only now recovering. Earnings are also recovering from historically depressed rates. All these factors exaggerate both the weak trend in GDP and the pace of growth in S&P 500 earnings from continuing operations.
Caveats rendered, the data is still enormously interesting. In the four years of the bull market to date (2009 through 2012), U.S. GDP growth averaged 1.48%; S&P 500 earnings from continuing operations averaged 15.3% growth; and the ratio of earnings to GDP was a whopping 10.4-times.
GDP and EPS: Explaining the Widening Disconnect
The S&P 500 is comprised of U.S. multinational corporations, almost all of which are domiciled in the United States. Why, then, is the relationship between U.S. GDP and earnings growth not just feeble, but actually weakening? The key reasons for this widening disconnect include more efficient and flexible corporate earnings structures; productivity; globalization; currency trends; and the zero-sum game in which mega-cap companies chip away at smaller companies' market shares. While the relative contribution from each factor moves around a bit, on a net basis, we expect S&P 500 earnings power to sustain and perhaps expand on its advantage over U.S. GDP growth.
We begin with the efficiency and flexibility of S&P 500 component companies. We discussed this in detail in our mid-May report, titled "From Top to Bottom-Line, U.S. Multinationals are Structured to Earn." Schooled by the harsh lessons of the 2001 and 2008 recessions, U.S. multinationals learned to shepherd cash (made easier by low prevailing rates of interest) and to add flexibility and variability across the operating structure to reduce the drag of fixed costs in a downturn.
On the top line, these companies have learned to flex revenues by working with local partners, thus laying off risks from regional downturns. On the cost of goods line, supply chain efficiencies, software-driven procurement, lean manufacturing, six sigma, and particularly contract manufacturing all improve manufacturing efficiency. Companies have flexed operating costs via stock option compensation and to variable compensation by being linked to performance metrics.
Earnings drivers below the operating-cost line are equally powerful if less understood. These include reduced debt service (related to debt issued at low rates), lower tax rates from more global business, and reduced share count in the EPS equation as a result of share repurchases. Growth in stock buybacks and dividends is consistent with more structured and more shareholder-friendly capital allocation programs, also increasing the attractiveness of equity investing.
This focus on operating efficiency and flexibility is being enacted one P&L at a time. There is also a range of more universal or global forces that are widening the gap between U.S. GDP and S&P earnings. Technology has become a massive productivity driver, resulting in ever-cheaper computing power, ubiquitous mobile computing via smartphones, and cheap and efficient digital communications.
The next iteration of technology, based around analytics, big data, enterprise mobility, and particularly the cloud, should drive even more meaningful productivity gains. The rise of cloud (utility computing) and related functions such as infrastructure as a service and software-defined data centers will disrupt the physical data center much the same way that contract manufacturing ended dedicated manufacturing within the technology industry.
The single biggest earnings driver for the past decade has been globalization. Argus Chief Investment Strategist Peter Canelo points out that foreign profits, from less than 17% of total U.S. corporate profits in the early 1990s, now account for more than 42% of S&P 500 profits and more than a quarter of total U.S. corporate profits. Together, globalization and productivity are keeping a lid on labor costs, and are enabling companies to deliver more on the bottom line.
The dollar has strengthened against the U.S. trade-weighted currency basket in 2013, mainly because of the plunge in the yen. But the longer-term trend of dollar depreciation (down more than 50% since 1985) has steadily enhanced the competitive position of U.S. multinationals while improving the repatriation benefit from overseas sales and earnings.
A final earnings driver for the S&P's multinational components likely comes at the expense of, well, everyone else. Being dedicated capitalists, we do not believe that earnings are a zero-sum game; capital begets capital. Nonetheless, these companies contain competitive advantages that allow them to invade nascent market niches and price out the start-ups and early adopters. When U.S. GDP shrinks, not every company feels the pain equally.
Conclusion: S&P 500 index price tracks EPS, not GDP
Between 1980 and 2012, the S&P 500 averaged 9.0% capital appreciation, S&P 500 earnings advanced an average 7.4%, while GDP averaged growth of just 2.64%. Between 1990 and 2012, the S&P 500 averaged 7.9% capital appreciation, S&P 500 earnings advanced an average 7.7%, while GDP averaged growth of just 2.42%.
The relationship breaks down somewhat in the 2000-2012 timeframe, with the S&P 500 averaging puny 1.5% capital appreciation - more in line with 1.73% GDP growth than with 7.2% annualized EPS growth. But, between the end of 2008 and the end of 2012, stock prices rose 12% on a compound annual basis, S&P 500 EPS posted a 15% CAGR, and the annual change in GDP was just 1.48%.
Equity investors who build their investment strategies around the change in U.S. GDP are missing a big part of the picture. Those who project market returns around S&P 500 earnings from continuing operations have a better chance of return alignment.