Dissecting Stock Returns: Financial Engineering or Genuine Growth?
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Welcome the money for the rest of us. This is a personal financial on money, how IT works, how to invest IT, how to live without worrying about IT. I'm your host, David stein.

Today is episode 4 fifty eight。 It's title, disease, stock returns, financial engineering or genuine growth. I recently read an article by columnist and associate editor of the financial times, rona for ruhar.

SHE used a phrase I hadn't seen before, financial zed growth. We've discussed financialization in the past, which is the the increasing role of financial motives and markets, financial actors and institutions in domestic and international economies. And that's from a definitions from jailed estein.

But I hadn't really put that word financialization with the word growth. Ruhar referenced a paper that came out last summer by principal economist at the federal reserve, Michael mang ski. The paper is title the end of an era that coming a long run, slowdown in corporate profit growth and stock returns.

He is predicting stock returns are going to be lower because the returns were boosted by an an element of financialization, namely lower tax rates and lower interest rate. And and we'll take a look to see is that financial zed growth if IT is the growth, in this case, corporate profits was due to lower interest rates or lower tax rates. In the paper smaland c, right from nineteen eighty nine to twenty nineteen, the S M P five hundred index grew at an impressive real rate of five and eight percent per year, excluding dividends.

During the same period, the U. S. Economy grew at a real G D P growth rate, GDP being in the measure. The value that output produced IT grew at two and a half percent per year. And in reading this and going through the analysis, I misinterpreted what the author said.

I thought he said corporate profits grew at five and a height percent per year, while the economy grew at two and half percent IT. Turns out that five and half percent was the Price appreciation of the index, which was driven by corporate profits, which grew at three point eight percent per year on a real basis. That does mean that corporate profits grew faster then the economy.

That's not Normal. It's unusual. Generally speaking, corporate names either on animal basis or real basis, grow at the same rate of the economy. And I went to one of my favorite sources to to confirm some of this data is question research found by ed esterton some fantastic on many aspects of the stock market.

In fact, crest mine has a beautiful chart that shows the drivers of stock returns that we use on money for the rest of us. We use an asset camp, namely dividend yields, earnings growth and the change in valuation. And they do this stack bar chart that i'll linked to in the notes that shows how much of of a decades worth a return was driven by those three factors.

And we'll see over the past three or four years, the ten year returns that most of the appreciation in the U. S. Stock market has been and driven by the change in valuation stocks getting more expensively.

We do show that historical attribution on asia camp, but IT IT was fun to see IT in this bark chart format, to see wow in neon Green. The expansion of the pe really elevates the return. So I I looked at, respond, researching, and he had interesting statistics.

This is through the end of two thousand twenty two, since one thousand nine hundred and fifty to seventy three year period, every year except two thousand and nine and twenty twenty has said positive noral growth in the economy. This is before backing out inflation. Typically when GDP is quoted is quoted native inflation.

So on a real basis and we can have A A negative real GDP growth. But once inflation is at a back IT could be positive. Only two times has there been negative nominal GDP earth two thousand nine and twenty and twenty.

There has been nine years or twelve percent of the time where real economic growth, excluding inflation, has been negative thirty four percent of the years. Overall earnings for the S P five hundred have been negative. In other words, earnings for companies across like A U.

S. Stock index or a global stock index, they are more violated than economic growth over time. They tend to track economic growth, and i'll share that with you, but it's not in lockstep. There's another paper that I found by Jason che j. Ritter and a couple other authors where they looked at emerging market stocks and the ideas while GDP growth in developing countries is higher and that should quit to higher returns in the stock market, and they looked at fifteen emerging markets and developed markets. They point in out GDP was not a great predictor of stock returns because they don't work in lock step over the long term, there is a correlation between economic growth and corporate profit growth and stock returns, but the cycles can differ.

What those authors found is that what does corporate well, a stock returns is earnings growth on a per share basis and and dividends per share well, and we know that because that's the math, the underline stock returns, like we show an asset cam. We highlighted this point in the newsletter we sent out this month for asset camps subscribers, where we point IT out that here stock returns, global stocks are up over sixteen percent year to date. And we wanted to see what drove that.

Was that being driven by earnings? Or was that being driven by the stock market getting more expensive? And we found IT was because stocks got more expensive. Earnings declined two and half percent year to date for the global stock market IT, a period where namal of GDP is actually increased. We have had an earnings decline, but we've seen valuations get more expensive.

The Price to earning to a show of the msci all country world index was nineteen twenty two at the end of november twenty and twenty three IT was sixteen point three at the beginning of the year. And so the appreciation in the stock market at sixteen percent return is because investors are willing to pay more for a dollars worth of earnings. Now that's not unusual because stock market investors are forward looking.

If the consensus that earnings will increase, the stock market will tend to appreciate first before the earnings catch up. And that's what we've seen this year. At the beginning of the year, the end of twenty, twenty two analyst, a bottom up consensus, the global companies and what analysts expect they're going to earn.

And then at the index level, they anticipated earnings would grow three percent, twenty twenty two so far through november, they fall in to in a high percent. But if we look at what's the latest estate earnings going out the next year, analysts expect earnings global earnings to grow close to ten percent. So with higher earnings expectations, that tends to lead to higher stock market returns, especially when some of the the headwinds facing the stock market, such as higher interest rates have eased.

Awesome because interest rates have follow. Now I wanted to confirm the data that sankei put in his piece because he was looking at grabbing data called crisp data, the center for research and security pricing. He was looking at IT on an aggregate basis.

When we talk about the drivers of of stock index returns, the earnings number, theirs is earnings per share from one thousand hundred and sixty nine december through the q three twenty twenty three learnings per share for the M S C I U S A stock index, which is very similar to the S P five hundred index. It's it's a size waited index. Earnings per share has grown six point three percent per year, the same as Normal GDP growth over that time frame, six point three percent.

What have found fascine though, is that Normal 的 GDP growth group aster from one hundred and fifty nine to one thousand nine hundred eighty nine and twenty year period， we a omino GDP growth of eight point four percent and earnings per share growth of six and a nine percent. So earnings per share didn't keep up with nominal GDP growth. And in my yancy's paper, he he goes back to one thousand nine hundred and sixty two three, one thousand nine hundred eighty nine and then he looks at from one thousand nine hundred eighty nine through twenty and I took the analysis from one thousand nine hundred and eighty nine through the the third quarter of two and twenty three.

During that period, nomo 的 GDP growth was four point nine percent compounded versus six point three percent earnings growth。 So earnings grow faster than GDP, which is the point of small yancy's paper. He wants to understand why is a growing faster than GDP growth when typically it's either matched IT or in the case of the twenty period from sixty, ninety, eighty nine IT was a little lower.

His calculation is that that forty percent of that growth in real corporate profits from one thousand nine hundred and eighty nine through twenty nine nine was due to reductions in interest rates and corporate tax rates. And as proof that he looked at, how did earnings before interest in taxes grow for those two periods from one thousand nine hundred and sixty tude? At one thousand nine hundred eighty nine IT was two point four percent earnings before interest in tax growth, and from one hundred and eighty nine, the two and nineteen IT was two point two percent about the same.

Yet earnings grew faster than the economy. Now the other influence was certainly lower interest rates, lower corporate tax rate. But there were more buybacks per share since one nine hundred and eighty nine than there was the prior period.

On the other hand, the dividend yield has been lower since one nine hundred and eighty nine and IT was prior. And and that makes sense if companies are deciding instead of paying dividends to take their cash and purchase shares, what that will do is IT will lower the divine yield and increase the earnings per share growth. And that's what happened.

But ultimately, the earnings per share growth was also higher because of lower interest and taxes. And that smile this point that this is financial engineering financialization. And the question is, can that continue going forward? Will they lower tax rates even further? Probably not, given the size of the deficit and the national debt.

Will interest rates fall from where they are today potentially? But we had super low interest rates over most of that period since the one thousand nine hundred and eighty nine. But that's not all that's going on there. And this is where I can I can be a chAllenge in comparing periods that the market is different now that the companies that make up the market are different. This is from and up.

So we did a few years ago that I link to in the shower notes, think it's episode to nineteen, that the credibly sinking stock market, and one of the things in this wish work by restores, and he pointed out that companies expense a lot more of their expenses of their intangible asso. IT could be a research expense. So IT could be the research and development IT could be purchasing something else that run through the income statement.

So it's it's not capitalize IT. So it's it's not this asset. Added to the baLance sheet, the companies that can capable something.

And so it's it's an asset. And then I could added to the baLance ship. And then IT is appreciated over, let's say, twenty five years or IT could be bought and expense that year.

The second approach were lower than that income. And his point is there because there's more services businesses compared to manufacturing that dad has LED to more expensing versus capitalizing those expenses. And that has also contributed to potentially lower earnings growth.

Today, both article earnings grows is higher. And so that is another argument, even though though there's been some underlying change in the structure in terms of the type of companies that those lower interest rates and lower tax rates did influence the higher earnings growth. The U.

S. Earnings go purchase going faster than economic growth, which is an anomaly. Another paper that stalls stood with further ichang amman. This is a working paper issued by the bureau conomo research. There is a thing while public intrade stocks aren't really representative of the economy, and we've done an epsom, that a link to the stock market is not the economy, we know that the learning cycle for the stock market doesn't follow GDP growth exactly as we've discussing the epsom more valuable.

One of the things that they point out is that just because a stock has a very large market capitalization, so IT sizes is big and looking at the number shares outstanding times surprise, that doesn't necessarily mean that company has the same impact on the economy. There isn't A A one to one relationship, nor does he have a necessarily big impact on employment. A A company could be very, very large, for example, because he doesn't pay its workers very well, so its profits or higher.

Now that might not be sustainable. But the size of a company as represented by the stock prize, the market capitalization, again, that's not necessarily connected to how it's contributing to economic growth. Seeing that the number of publicly traded companies is actually shrinking.

In one thousand nine hundred and ninety six, there were about eight thousand firms that comprise U. S. Stock market. Now it's less than four thousand. Even though the economy is many times bigger, there are less publicly traded companies then.

They were now partly that's because the economy, as I mention, is more service oriented and service space companies tend to be smaller compared to manufacturing. So the nature of the stock market has changed. There are fewer manufacturing firms in one thousand nine hundred and seventy three, for example, manufacturing that sector employed the most workers of any sector in the U.

S, but the overall number of many fashion workers has declined thirty percent between one thousand nine and seventy three and two and nineteen, even though the economy again is much bigger, much bigger with more service oriented companies. So so what we're looking at then as we think about IT, is the growth in the stock market or stock Prices is the financial engineering? Or is there something underneath is IT just because corporate tax rates are lower or interests lower or just because people are bidden up the stock Price? It's some of all of that.

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At linked in, that comes left, David. That's linked in. That comes last, David, to post your job for free. Terms and conditions apply. Stocks have gotten more expensive over time, but if we go back to one thousand nine hundred and sixty nine, IT doesn't have as great of impact as I would have thought.

The Price earnings ration of stocks in one thousand nine hundred eighty nine fifteen point two at the end of the third quarter is for U. S. ox.

The P. E was twenty three point eight that contributed about zero point eight percent tage points to the the close to ten percent return for U. S. Stocks analyzed over that period.

Dividends contributed just about three percent and the earning per share growth, as we've mentioned, was six point three percent per year, in line with the overall growth of nominal GDP. Now definitely, corporate tax rates influences that. Lower interest rates influence that at least the latter couple decades.

But that was just part of that. Underneath that, we had the type of company switching from fewer manufacturing, more service or the companies. And the overall number of publicly traded companies is less today than IT was twenty or thirty years ago.

One of the other drivers of that, though is private equity firms that do leverage to buyout a part. The ship, for example, will borrow money, perhaps team with another bio partnership, and they'll take a publicly traded company, buy up the shares and take a private in there, two thousand, about four percent of U. S.

Corporate equity. And that would be public in in private was companies owned by these leveraged buyout firms or partnerships in twenty twenty one is about twenty percent. So we have way more leverage BIOS. Then we did.

And there was an article by rogate karma in the atlantic that was fairly negative tard leverage bia felt that having many more private companies outside of public scrutiny was a bad thing now that there are can be some less attractive elements to that, but there's regulations that, that could overcome that. But one of the changes is back in ninety ninety seven, there was was a new law pass that allowed these private funds to raise an unlimited amount of capital from institutional investors. And and one hundred and ninety seven essentially was the peak in terms of the number of public companies outstanding.

There has been a huge amount private equity leverage pilots. They do that. They take out massive amounts of debt and then they try to make the company more efficient, often by laying off employees, but ideally by increasing productivity and growing revenue earnings.

That track record is mix. Some partnerships are able to do that, others do not. We do know that the number of companies and going public again is dropping.

Many these companies are staying private and being brought up by other private companies. The atlantic article pointed out that private equity firms, their ownership of nursing homes has grown from five billion back in two thousand to a hundred billion today. There is that potential conflict of interest in terms of are they running these homes to the benefit of their patients? First is trying to extract profits.

The atlantic article pointed to to one study that said there were twenty two thousand five hundred premature nurturing home death from two thousand five to twenty seventeen, even before the pandemic. And they suggested that was just over prescribing O P, O age, not having enough people, trained people providing service. It's hard to say that, that was one study, but they are giving private equity leverage files and negative report.

I was interested to see whether taking on this additional debt by borrowing money to take a company private that is a formal of financial engineering, does that lead to more bankrupcy? I found one study that looked at all the us based publicly traded companies that were acquired in leverage BIOS. Between one thousand nine and eighty and two thousand six, there were four hundred sixty seven of them.

And then they look to see to the extent they went bankrupt and they found that. And is this number is down to me, about twenty percent of those leverage BIOS. They went bankrupt within ten years, eighty percent didn't, but that's twenty percent, whether those in the control group, only two percent when bankrupt within the first ten years.

That financial engineering, taking on that debt to take the company private, doing IT ever does to reduce expensive, increase sufficiency. Ten times more companies went bankrupt with these leverage BIOS. Now it's been more difficult for private equity firms to take companies public because the markets not always receptive to IT, but more difficult to the service, a debt or even the borrow money to take company's private than IT was.

So one of the things that these leverage bio firms and other I would equity firms are doing as they're doing what's called a net acid value loan, an nav one. They're basically going and borrowing money not to find a specific company or have that debt tie to out, but just based on the value of the overall partnership itself. And then they're taking those funds and basically, in many cases, just sending them back to the limited partners.

So instead of the traditional model where they they take a company private, they do their financial engineering, make a more efficient than do an initial public offering and then distribute those proceeds to the limited partners. Because the IPO market is not as open as IT was, they're often just borrow money based on the value, the private valuation of those companies and then distributed to the limited partners. And what that does is that increases the return, the eternal return of the partnership IT, increases the the amount of distributions to the paid in capital.

And that helps the market. The next fund, one plus member there was the asking us about this is how rampant is is this. And it's hard to get the data IT.

IT does appear bigger than IT was in terms of how will that impact the long term viability of leverage BIOS. We just don't know yet. It's too early because this is just really starting to ramp up.

But it's it's another example of financial engineering, in this case, boosting the return growth of a private equity fund by borrowing money and then sending IT back to the shareholders early. We could call IT in order to boost the returns. Now there's other ways this money can be used.

Sometimes it's actually is used to do an additional bio to help fund a bio. But it's another example that debt barring money can be used to boost returns in a form of financial engineering debt. And the interest on the debt influences corporate profits.

Lower interest rates have influenced how high corporate profits have been or the growth rate. This corporate profits and tax rates certainly can impact that. So in conclusion, when we think about stock returns, public and private, it's a combination of financial engineering and genuine growth.

IT is ultimately when we look at public stock returns, IT is driven by those drivers that we look at, at money for the rest of us on on asia campus. IT is the cash flow, the divided IELTS, the percent of profits paid out to shareholder others, profits growing. And it's based on what investors are paying for those profits.

Profits grow across the economy for public companies. Private companies, as economy grows, as there are more workers with more workers. And if those workers are becoming more productive in terms of what they producing, that leads to hire economic growth and that leads to hire stock returns, both public and private.

Now we've done episode, and I can guess that today, is that growth good? How high quality is that growth? Is a growth due to actually adding value, well being an abundance to people's lives? Or is IT growth due to, in in the perverse case, harming people in some way? And every company has to decide that for itself as the society as a whole, as investors.

We're invest in the public stock market, in many cases, generally index funds or ets. Some of us have exposure to private markets through leverage, buy out funds, the fact that earnings are more valuable and are disconnected a little bit, they track the over economic cycle, but the earnings are more volatile, and that leads to greater volatility for the stock market. And there's one other statistics I anna share from crest mont research I link to IT in the showers.

It's something that we've talked about that volatility of stock market in our earnings lowers overall returns. And they go back to one thousand nine hundred through twenty twenty two and look at the average annual return for the stock market in at seven point four percent. This is the dalziel industrial average.

If we look at the compound return, the geometric return over time, the analyze return is five point two percent. It's lower because of volatility drag. It's lower because stock goes up.

They lose money than he has turn more to recover. And the mathematics of compounding reduces the overall return. And so the reality is that we can invest in the economy directly.

If we could just earn GDP growth every year, that nominal GDP growth, we would have so much more wealth than we were just investing in the stock market because GDP growth on a namal basis is less volatile than than earnings and because earnings are more violates le the stock markets more volatile and that leads to a lower geometric return. And that's just the nature of investing. Those are some thoughts on genuine growth versus financial engineering.

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