After Iraq: the Real World of Earnings

I wrote about a study last year that suggested corporate earnings in the US could not grow by more than the growth of GDP.

"Our median estimate of the growth rate of operating performance corresponds closely to the growth rate of gross domestic product over the sample period ....the growth in real income before extraordinary items is roughly 3.5% per year" (after inflation and dividends. Before them it is about 10%.) "This is consistent with the historical growth rate in real gross domestic product, which has averaged about 3.4 percent per year over 1950-98. It is difficult to see how over the long term profitability of the business sector can grow much faster than overall gross domestic product. " (From a National Bureau of Economic Research Report by three economics professors: Chan, Karceski and Lakonishok).

While there are firms that are, of course, exceptions, this should not come as a real surprise. GDP is the average of the growth in the economy. Thus companies on average cannot grow earnings faster than the total economy.

But today, we are going to look at a study from two of America's premier investment research minds which shows that it is not even true that earnings grow as much as GDP. When you actually slice and dice the numbers you come up with a few rather interesting observations.

Rob Arnott is chairman of First Quadrant, which manages about $15 billion. He is also the editor for the Financial Analysts Journal, one of the most prestigious investment journals in the world. I have written of his research in several past letters. William J. Bernstein is a principal with Efficient Frontier Advisors, LLC, and the author of numerous important studies.

I mentioned to Rob that I am working on the chapter on earnings for my book-in-progress, and he graciously sent me a report entitled "Earnings Growth: The Two Percent Dilution" that will be in the Fall FAJ. While I cannot quote it directly, he has allowed me to paraphrase its more important findings.

Investors think that earnings of existing companies can grow faster than the economy. There are two reasons they are wrong. The first is that much of the growth in the economy is actually due to the creation of new companies. Their growth does nothing for the earnings of existing companies. During the 20th century, the study shows that stock price and dividend growth were 2% less than the actual macroeconomic growth of the country.

The second false belief is that somehow stock buybacks will allow per share earnings to grow. While this may be true for an individual company, when looking at the entire universe of companies, you find that new share issuance almost always exceeds stock buybacks, by around 2% per year. We will look at some actual numbers and then go into the very real investment implications.

Since 1800, the US economy has grown about 1000 times. The record is remarkably consistent, averaging around 3.7% per year over that time. The good news is that economic growth over time is consistent. The bad news is that there is no reason to think a "new paradigm" could make it grow appreciably faster. We have had numerous "new paradigms" in US history: railroads, automobiles, electricity, the cotton gin, the reaper, telephones, etc. They all provided a major boost to the economy. But none allowed it to grow above that trend line for very long.

But things are different now, are they not? Did not earnings grow in the 90's at very high rates? Why could we not see that repeated?

Arnott gives us three reasons. First, we started the decade with a very low base, due to the recession. Measuring growth from trough-to-peak and then projecting the growth as far as the eye can see is what causes bubbles, and is almost always wrong. (Actually, I cannot think of a time when it wasn't.)

Second, write-offs were frequently ignored, and more and more emphasis was placed upon pro-forma earnings. While this may be useful when looking at one company, when looking at the economy as a whole, there are no extraordinary items. Everything counts.

The peak earnings of the latter part of the decade included three very suspicious parts: not expensing stock options, pension expense and "earnings management." Combined, Arnott presents evidence that this could have inflated earnings as much as 30-35%.

In discussing rapid earnings growth, Arnott points out that the period from 1820-1855 actually saw a far greater technological explosion and resulting economic growth. In 1820, information and trade moved at the speed of a horse. In 1855, speed had grown tenfold and communication was almost instantaneous. While someone from 1967 could recognize the world of 2002, someone from 1820 could not even imagine the world of 1855. The growth of the first period was over six-fold, and was four times greater than the tech revolution we have just experienced. Looking back on a chart of 200 years of growth, the recent years hardly even show an acceleration in the trend of growth!

Since 1871, real stock prices (after inflation) have grown at 2.48% while the economy grew at 3.45%. There is almost 1% of "slippage." Bears could paint a bleaker picture by pointing out that much of the growth was from an increase in valuations. By that I mean, P/E ratios increased substantially. Investors were paying more for a dollars worth of earnings. The market was valued at an average P/E of 12 for periods (or 20 times dividends) prior to the last bull market. The current high valuation levels are approaching 30. Almost 1% of the growth of the stock market over the past 130 years has been due to the recent bubble in prices.

Wait a minute, what about the studies which show the S&P 500 grew at 10% a year? Part of the answer is that these indexes include dividends which averaged almost 5%. You have inflation which accounts for a great portion. And part of the answer is that the indexes do not reflect the actual results of the companies. If you measured the Dow or S&P by the companies that were in them in 1950, as an example, the growth would not have been as much. That is not to say the Dow should be fixed. They make the changes to reflect the broad economy, which is what the Dow and other indexes are supposed to do.

That is what makes index investing so attractive in bull markets, and why it is so hard for a mutual fund to beat an index. They keep adding fast growing companies and getting rid of the dogs. As valuations increase, the funds become self-fulfilling prophecies.

Nash-Kelvinator, Studebaker and Other US Giants

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For instance, IBM and Coke were added to the Dow in 1932. Coke was dropped for National Steel three years later, and IBM was booted for United Aircraft in 1939. IBM was once again put in the Dow in 1979. Coke returned in 1987. National Steel has long since departed, as has Nash-Kelvinator, Studebaker (I learned to drive in a Studebaker.), something called the Texas Company and American Beet Sugar. Let's hear it for progress.

For those with no life, or the insatiably curious (I will leave it to you to decide in which category I am placed), you can go to and see the entire history of the Dow.

(As an aside, if anyone knows of a study which shows what $1,000 invested on October 1, 1928 [when the Dow was expanded to 30 stocks] on a buy and hold till today would have grown to, I would be interested in the study.)

Clearly, buying the component stocks of the Dow and holding them for long periods would not have produced the same returns as the managed index.

I would invite readers to think about the implications of this for one moment. While today we might smirk at Nash-Kelvinator or Studebaker or American Beet Sugar, or any of the scores of firms that have been added and dropped from the Dow, at one time they were considered worthy of inclusion in the most prestigious roll call of companies.

Proponents of buy and hold use indexes to support their claims of its effectiveness. Indexes, however, are not instruments of a strict buy and hold philosophy. They clearly buy and trade. For every GE which was added to the Dow in 1896 and then dropped in 1898 for US Rubber, and added again in 1899, dropped in 1901 and added yet again in 1907, there are scores of other firms which were once a part of the mighty Dow and have now faded into oblivion. None of the other earlier companies from 1900 are names which are familiar to me, except as historical curiosities.

Thus, when Arnott shows actual earnings growth is much less than index growth, it should come as no surprise. The various indexes are comprised of growing companies. The overall economy does not perform as well.

I will not go into it at this time, but I think I have clearly documented in past letters that index investing in secular bear market periods, like we are in today, is a prescription for deep disappointment.

For foreign readers, of which there are now many, let me briefly discuss Arnott's study of 16 world markets. Using data from the tour de force book by Dimson, Marsh and Staunton called Triumph of the Optimists, he shows that even in countries which did not experience significant war-time damage, the experience of the US was not unique.

Dividend growth and per capita GDP growth are always materially below GDP, with the odd exception of Sweden, and there the number was only minimal. The actual real growth of dividends for most countries was actually negative!

There is an interesting implication which Arnott addresses. Many suggest the next new waves of wealth will be built on biotech or nanotech or the internet. But what happens is that new firms increasingly make the capital and investment of previous firms obsolete. OK, just one small quote: asks Arnott, "How many of the new paradigm crowd truly believe that their beloved tech revolution will benefit the shareholders of existing enterprises remotely as much as it can benefit the entrepreneurs creating the new enterprises that comprise the vanguard of their revolution?"

Who is Buying Back What?

What about stock buybacks? Can't they increase earnings per share and allow earnings to grow faster than GDP? The answer is that in theory they could. In practice, there is actually an average of a net 2% creation of new shares each year and thus an actual 2% dilution of earnings over the broad markets.

The implication of the study is that investors who are looking for growth in stocks based upon the belief that earnings can grow faster than the economy are going to be disappointed. And if, as I believe, we are in a Muddle Through Decade of lower than historical average economic growth, then it is possible investors will be disappointed more than they normally would.

Recession, Rebound or Muddle Through?

US retail sales rose 2.1% last month to $311.5 billion, the largest increase since October 2001, after falling 1.3% in February, the Commerce Department said. The University of Michigan's preliminary consumer sentiment index jumped to 83.2 this month from a nine-year low of 77.6 in March. The trade balance actually (very slightly) improved. The stock market has held its own in recent weeks.

Oil prices are likely headed down, and that will provide a quicker and bigger boost to the economy than the tax cuts. If business spending picks up, as the Iraq war winds down in a positive manner, then things actually could look better in the second half.

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This growth, especially in sentiment, was especially surprising given the very negative employment numbers. It appears 500,000 jobs have disappeared in recent days, and lay-off announcements seem to be coming from everywhere. Remember, these were numbers which were generated when the press was telling us we were getting into a quagmire in Iraq.

So, are we out of the woods? Are boom times around the corner? The short answer is no. It is to early for any celebration.

David Leonhardt, writing in the New York Times, tells us that chief executives of large companies, perhaps the most accurate economic forecasters recently, expect the economy to remain weak over the next six months but do not foresee a new recession, according to a survey released yesterday. (These are the people who also control capital spending decisions for new business expansion.)

Only about one company out of 10 plans to increase employment in the United States in that period, according to the poll of 120 chief executives by the Business Roundtable, an association of leaders of large companies. The rest, some 90% of companies, are divided almost evenly between those that plan job cuts and those that expect to hold employment at current levels.

The message from my Three Amigo indicators is also mixed. High yield bonds are jumping, which says things are getting better for companies down the food chain, and that many problems have been worked through or already discounted. But capacity utilization is simply terrible, and not responding at all to any type of stimulus. The ISM index (purchasing numbers) is right in the middle of being not good but not bad. In short, according to my favorite bellwethers, it could go either way.

As I have written here in past letters, the economy in Europe is materially slowing down. The Financial times writes, "The eurozone economy may have contracted in the first quarter of the year, the European Commission said on Thursday.

"The Commission said on Thursday it had trimmed its estimates because of sluggish demand and uncertainty linked to the Iraq war, forecasting first quarter growth between -0.2% to 0.2%, and second quarter growth at 0.1% to 0.4%." That could easily translate into two quarters of slightly negative growth.

If the euro continues to rise, there will be further economic decline, as European businesses will feel increasing competitive pressure. I continue to predict that European businesses will be screaming within another 10% decline of the dollar for their central bank to halt the appreciation of the euro.

The IMF, among other groups, is forecasting a potential recession for the world. More stimulus, the cry to the world's central banks, like an engineer screaming for more coal in his steam engine.

The US economy looks like it will have grown somewhat north of 1% this last quarter. That is certainly not good, but it is also not a recession. It is quite possible that we could get a "war" bounce. Or not. It is frankly too early to tell. It seems like 49% of analysts feel we will, and another 49% think we will not. There are 2% of us who admit we do not know, but if we wait a month or so we will find out.

My current belief is that we still Muddle Through this year with less than 2% growth, if that. And that depends upon a weak rebound. Stay tuned for the next very critical month. We will have to watch the statistics for signs of life or slowdowns.

Iraqui Debt - Who Owes It?

Japanese Finance Minister Shiokawaproposed that the G-7 countries and others forgive all of Iraq's debt, as a way to help them get started again: not postpone, or re-negotiate, but forgive. Excellent idea. Of course, Russia, France and Germany, to whom much of the debt is owed, will not be happy. I would suggest that we allow those nations to take as much of the wealth of Saddam Hussein and his henchmen that they can find anywhere in the world in re-payment. Those evil men stole it from the people of Iraq, with the direct complicity of these countries, much of it in contravention, it now is clear, of the UN rules they so piously espouse. These countries have already gotten billions from Iraq, much of it illegally through Syria. The US spent billions to free to the Iraqi people. They should donate to the cause if they truly care about the people as they proclaim. I will not hold my breath.

On that note, I find it fascinating that after arguing for years that sanctions should be lifted on Iraq, these Security Council members are now fighting the notion unless they are assured they will still get their blood money. It will be interesting to see in a few months, when there is a legitimate interim Iraqi government, whether they will release to the Iraqi people the $40 Billion that the UN is holding. Watch the fight. We will see who cares about people and who cares about money. The US and Britain will not take one oil dollar, and the Arab street will see their "friends" fighting over the spoils.

Hear Me Now, Search Me Later

You can now go to my web site,, and download an audio version of this e-letter. Clarynx Technologies ( gets my letter and has a software program which translates my words into the spoken word. It does not sound quite as good as a HAL 9000, but it is pretty amazing nonetheless. Let me know if this is of interest to you. I am curious as to whether anyone would want to use this, and/or how you like the technology.

Also, you can now go to my archives on the website and search for specific words over my last 2.5 years of work. The software even ranks the various letters according to its definition of relevance. For instance, I have quoted Rob Arnott on several occasions. You type in Arnott and you get 7 different letters. It seems that I have written about Greenspan in 73 different letters.

My book is coming along. I am still trying to meet my May 15 deadline. I am quite excited, as I believe the book is going to be a great educational tool for investors, and will help you manage your portfolios with better results,

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This e-letter has grown from 1,500 readers in the summer of 2000 to almost 2,000,000 this week. I am both humbled and amazed at the response, and thank you for taking the time to read me.

Some Personal Notes

A few things have crossed my desk which has helped put my daily problems in perspective. I got an e-letter this morning from my friend David Griffis. Terri, his wife, has been battling with various serious cancers for the past two years, with multiple operations, radiation and miscellaneous therapies. They thought they had it under control, but last night found it is has become much worse. The doctors only give her a few months without God's intervention. David's story of his family meeting with his seven kids was one of the more moving letters I have read in recent years. Pray for Terri and David and the kids.

My daughter, who works in the next office, has started working with a "Last Resort" non-profit poverty agency called Northside Interchurch Agency. This recession and slowdown has put a lot of pressure on their services and others like them. There are now a lot of people who have never known what it is like to not be able to afford toothpaste or diapers for their children. Each week Tiffani talks to people embarrassed to ask for help and families having tried all agencies in the area. This agency becomes their last resort for food, clothing and the basics. This agency turns 96% of their income and donations back to the community.

This has been an eye-opening experience for her. The needs are not just in Forth Worth, but everywhere. I urge you to find a way to help in your local area. There are those who have written and said they wanted to pay for this letter. In lieu of a subscription, consider helping this agency through Tiffani or some group working with those who are suffering because of this slowdown. If you would like to help Northside Interchurch Agency, simply reply to this letter and ask Tiffani to send you information, and address for a tax deductible gift, or she will be excited to call you back if yon would like to know more. (They don't have a budget for a website.)

So, I don't have problems. I have a great marriage. My wife and 7 kids are all healthy. I have a comfortable lifestyle, lots of friends and great business prospects. Putting it in perspective, I have some problems which will get worked out soon. I am grateful.

Quickly, I am looking for a house to rent in Maine that has an ocean view and high speed internet access (must have) for a few weeks this summer. I have promised my wife (no kids!!) we will try to escape the Texas heat. If you know of some place in Maine, or similar view and peaceful location, please let me know.

Your recognizing life is pretty good analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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