Fed Working Paper - 40% of real corporate profit growth after 1989 was fueled by a decline of interest rates and corporate tax cuts.

[daniellea]

Full PDF: https://www.federalreserve.gov/econres/feds/files/2023041pap.pdf

Author (Michael Smolyansky, Principal Economist of the Federal Reserve) says in the abstract:

I show that the decline in interest rates and corporate tax rates over the past three decades accounts
for the majority of the period’s exceptional stock market performance. Lower interest expenses
and corporate tax rates mechanically explain over 40 percent of the real growth in corporate profits
from 1989 to 2019. In addition, the decline in risk-free rates alone accounts for all of the expansion
in price-to-earnings multiples. I argue, however, that the boost to profits and valuations from ever declining interest and corporate tax rates is unlikely to continue, indicating significantly lower
profit growth and stock returns in the future.

From Fig 1, interest and tax went from 50% of EBIT to maybe 25% today.

He concludes that EBIT is now constrained to increase at the economic growth rate of

 

[sisi]

@daniellea Thanks for the link. I read the entire paper and appreciated the author's style in making the paper as approachable as possible (it's a quick read as far as academic papers go).

Its conclusions are consistent with the discussion regarding corporate profits from the perspective of the Kalecki-Levy accounting identity.

Changes in government policy have provided a strong tailwind to rising corporate profits, whether that came in the form of lower corporate tax rates (deficit spending) or lower corporate interest rates (lower government rates). This tailwind cannot continue in perpetuity for practical and structural reasons. I appreciate the author's effort to quantify the effects of each in a way that was simple to understand for nonacademics.

 

[daniellea]

@sisi Would you say the following is a good summary?

StockReturn = (P/E)[sup]-1[/sup] + PolicyChangeDriver

Because PolicyChangeDriver is exhausted (taxes low, rates low, at least in 2019), we are back to

StockReturn = (P/E)[sup]-1[/sup] = 4%

Then something has to give - either the equity risk premium (ERP) stays high (real returns of TIPS are pushing 2%, so ERP is just 2%, vs historical ~4.5%) and stocks have low returns. Or stock prices fall by 30% to restore historical P/E=18 and returns of over 5%.

 

[sisi]

@daniellea A significant ERP must always exist in normal market conditions, and any attempt to value the stock market purely on present and future earnings with an implied ERP of 0 will lead to the conclusion that stocks are undervalued in all but the most bubbly of conditions. The ERP represents a lot of mathematical but also sociological/psychological trends and distills them into one number.

The author notes that another way multiples can expand rationally is if companies start passing through a higher percentage of their earnings to shareholders. However this metric is already high.

As a side note, be aware that ERPs can be derived with different assumptions. 4% ERP when calculating the intrinsic value of an index by using operating earnings as opposed to net income will lead to very different conclusions, but when analyzing a time series of data, as long as you are consistent there is no problem. But it can be misleading to talk about ERP without referring to which kind of earnings you are basing the ERP on. Operating earnings is the industry standard, though net income is more accurate.

Generally the ERP is derived from the other variables in your pricing model, as it is the last variable that one calculates to reconcile your model to market prices. This is because in markets, we see the price, then work backwards to rationalize it -- we don't use the data to derive the price. I can rationalize/legitimize almost any market price by changing my risk premium and growth assumptions, which is why ERP is the ultimate fudge factor in valuation models (there's nothing wrong with that, we just don't know any better way).

By the way, even though the paper is great, I would caution anyone from drawing very strong short to medium term conclusions. The ideas are simple and powerful, but markets and economies are complicated. Although this paper was published very recently, everything the author said applied equally in October 2022 and could have been published then as well. Earnings have been far more resilient than most economists would have predicted 9 months ago, and the SPX has risen around 20% since.

The paper is useful for clarifying the basic assumptions regarding what needs to happen in the long run for growth to be maintained at present levels and makes a common sense argument as to why these conditions are unlikely to continue. You can also view this paper through a historical lens as an explanation for why the US market has done as well as it has. It says nothing about short term market behavior.

 

[daniellea]

@sisi

You can also view this paper through a historical lens as an explanation for why the US market has done as well as it has.

I'm thinking it might justify a move to rebalancing into non-US investments. I've read that most of the superior historical performance of the USA's stock market accrued over the past decade.

(edits: word choice, precision)

 

[jackman915]

@daniellea Perhaps one should look for economies with high interest rates and high tax rates which have a chance of declining with stable economic conditions.

 

[swammerdami]

@daniellea You should not use TIPS as a forward estimate of real returns or as a forward estimate of inflation rate expectations. The TIPS pricing mechanism is completely broken. TIPS have been pricing an immediate drop of inflation to 2.0% for every month since 2021. The pricing never corrects, the inflation forecast is proven wrong every single month, yet never adjusts. Always prices immediate drop to 2.0%. So best to be avoided at all costs as serving any prediction value.

 

[daniellea]

@swammerdami If you mean this figure from the gap between TIPS and T-bonds, then I would argue that TIPS are telling us that fair yields are inflation+2%, but it's the T-bonds that might be mis-priced (too cheap rates too low, because of persistent inflation).

But another wrinkle is that this is the 10 year rate using 10 year bonds, not the immediate short term change in inflation. Inflation is likely to be back to 2% in a couple of years.

I'm not using TIPS as a estimator of real returns, but as a factual statement what guaranteed real returns I can get right now, with 100% certainty. If I want 2% over inflation for the next 5 year, I can buy a 5 year TIPS right now. For 10 years, it's 1.6%.

 

[resjudicata]

@sisi "This tailwind cannot continue in perpetuity for practical and structural reasons"

Yes, but how long is too long? trying to incorporate this in investment decisions can be lethal as it's equivalent to trying to time the market.

 

[tshane]

@sisi So, were fucked unless there's a war we're directly involved in ?

 

[iammelchizedek]

@daniellea I find these arguments to be reasonably compelling. However, there are some possible rebuttals at first glance...

• So 60% of the corporate profit growth was from Other Things -- why couldn't these factors become more important or drive more profit growth in the future?
• The author himself notes the corporate tax rate was 35% still in 2016, or effectively 23%, and it's not as though the 1989-2016 stock performance was bad. I also just don't buy the argument that ""the deficit"" means tax cuts won't happen -- the deficit didn't stop the money printing in 2020 after all. Last time I checked up on American politics, 50% of the political parties were still keen on cutting taxes.
• the study ends in 2019, when the Fed Funds rate was substantially lower than it is now. So, we can be more optimistic about this aspect than the author back in 2019. and there is more room to cut than he could have foreseen.

 

[daniellea]

@iammelchizedek

why couldn't these factors become more important or drive more profit growth in the future?

They could, or they could go down as well. It's a coin toss.

and it's not as though the 1989-2016 stock performance was bad.

SP500 went up 5.4% per annum in real terms in 1989-2016, plus dividends (using CPI calculator and a price change from 350 to 3000 in SP500).

But in 1989, interest plus tax were about 55% of EBIT, but only about 27% in 2016 (Figure 1). If we recompute SP500 yield from 1989-2016, but scaling today's SP500 to pretend companies are still paying 1989-level expenses while P/E stays the same, the growth goes down to 4.1%.

The equation I use is to use CPI calculator to convert SP500 of $350 in 1989 to $727 in 2016 dollars, take the $3000 SP500 in 2016, and then

ObservedYield=(3000/727)[sup]1/[2016-1989][/sup]=1.054=(1+5.4%)

NoStimulusYield=(0.71x3000/727)[sup]1/[2016-1989][/sup]=1.041=(1+4.1%).

Again, all I did is assume that today's SP500 has the same P/E as it does today, but earnings drop from 63/100 to 45/100 of EBIT, a change of 45/63=0.71

So the effect is still big pre-2016.

also just don't buy the argument that ""the deficit"" means tax cuts won't happen

If this happens, it will be another transient kick, not a sustained growth source. The hangover comes a year later. The author's point is that these were short term boosts that the market priced as though they were long-term fundamental changes. The government gave a gift, and the market assumed the gift would happen every year, except that you can't drive rates or taxes below zero

the study ends in 2019, when the Fed Funds rate was substantially lower than it is now.

We have had one year of high rates, and by 'high' I mean 'over 2%'. This is a decades-long projection.

 

[iammelchizedek]

@daniellea

you can't drive rates or taxes below zero

rates can be below zero. it is a terrible idea, if you ask me, but other central banks have done so.

taxes have a long way to be cut before they get close to zero. I also don't personally advocate for corporate taxes to fall, but mathematically, it can fall lower.

The author's point is that these were short term boosts that the market priced as though they were long-term fundamental changes.

Disagree that the author proves this point with regard to tax cuts or deficit spending. The author actually says that virtually all of the P/E expansion can be attributed to the risk free rate falling (page 3). Therefore, based on the author's own point, this means that tax cuts only affected the earnings side, and not on the valuations or the "market pricing" side.

 

[daniellea]

@iammelchizedek

but other central banks have done so.

Negligibly. Central Bank of Europe -0.1% Sep 2019. Below this, cash in a vault is better, or you need to design currency that depreciates. Hundred dollar bills that reset their digits .... 100, 99, 98 ...?

taxes have a long way to be cut before they get close to zero.

Every tax cut is a transient event, giving a one-time boost to the market. The issue is that the market has interpreted it as "look, high annual profit growth" not "oh, we got a one time gift."

Actual taxes are at 21%. If they go to zero, then the stock market gets a 20% boost. But, wait .... it's already at a very high P/E, and this boost would merely take it back to to a still-high P/E=20 (or a high CAPE=24).

all of the P/E expansion can be attributed to the risk free rate falling .... based on the author's own point, this means that tax cuts only affected the earnings side, and not on the valuations or the "market pricing" side.

I said "these" were short term boosts - the plural meaning both rates and tax cuts.

Therefore, based on the author's own point, this means that tax cuts only affected the earnings side, and not on the valuations or the "market pricing" side.

I think you're concluding things that the author himself is not saying, by empasizing certain sentences.

What he said is simple: 40% of corporate profit growth in the period 1989-2019 was due to one-off, non-reproducible policy changes. Even if these changes are not reversed, profit growth should be 60% smaller (in fact, EBIT growth should be less than or equal to GDP growth). Any stock valuation scheme that attempts to extrapolate stock prices based on this period is suspect.

So if I buy VYM (paying 3%) based on its 6% real dividend growth, I might be in a for a nasty surprise, with a lot less income in 10 years than I anticipated. If enough people are disappointed this way, stock prices might readjust to meet the new expectation.

 

[iammelchizedek]

@daniellea

I think you're concluding things that the author himself is not saying, by empasizing certain sentences.

By emphasising certain sentences, you mean I'm literally saying things that the author has written, and pointing out the contradictions within.

Why don't you quote me the page and paragraph number where the author shows evidence that these "expectations" of a 6% dividend growth, or an imaginary 20% tax cut in perpetuity, have caused a change in current stock price? TTM earnings cannot be changed by expectations, and P/E must explain all other changes in the stock price.

 

[daniellea]

@iammelchizedek

Why don't you quote me the page and paragraph number where the author shows evidence that these "expectations"

I never said he said this. I paraphrased him as:

40% of corporate profit growth in the period 1989-2019 was due to one-off, non-reproducible policy changes. Even if these changes are not reversed, profit growth should be 60% smaller (in fact, EBIT growth should be less than or equal to GDP growth). Any stock valuation scheme that attempts to extrapolate stock prices based on this period is suspect.

The in the next paragraph, I gave a example of what the implications of that might be to me.

Analogy: Isaac Newton writes "Gravity makes things go down faster and faster." I infer "If I should drop an anvil on my foot, it might hurt very much."

 

[jessaking]

@iammelchizedek A drop in the corporate tax rate is what contributed to the growth. If corp tax rate stays flat, no growth from that. Do you expect the corporate tax rate to be higher or lower in 5 years?

 

[thriftypineapple]

@daniellea Yeah, this doesn't surprise me at all.

 

[crooklynbanks]

@thriftypineapple 1980-today Trickle-down economics

2009-2019 Basically no interest

None of this surprises me.

 

[thriftypineapple]

@crooklynbanks RIP Easy Money Era (2009-2021).