The greatest magic show I ever saw was performed by the famous illusionists, “Penn & Teller.” It was during a family vacation in Las Vegas about fifteen years ago, and to this day I cannot figure out how they did this trick.
The stage was a semi-circle, with the audience on three sides. They put on the stage a platform with legs underneath. Think of risers, but only one level. The bottom of the platform was about 18” above the stage floor and I could see underneath it to the person on the opposite side of the stage at all times. The platform was about 30 feet from the back of the stage, so nothing could get to the platform without my seeing. We, the audience, could at all times see underneath the platform and behind the plat-form. Penn & Teller placed the obligatory pretty girl dressed in skimpy clothing on the platform and then put up four walls around her. Again, at no time was the space between the bottom of the platform and the stage floor obscured. Neither was the 30 feet behind the plat-form. Penn counted to four, pulled a rope and the four walls fell down. The pretty girl was gone. In her place was . . . AN ELEPHANT! A real, live, breathing ELE-PHANT! Unless Penn & Teller was able to perform actual magic, this was the greatest sleight of hand I ever saw.
We all know how illusionists work. They get you looking at one thing, which is usually that obligatory scantily clad pretty girl, while they are doing something else. The way I view the stock market of 2022’s first quarter, this may well be another illusion act. Metaphorically speaking, everyone is looking at the pretty girl while an elephant is being placed on the platform.
Let us first review what a stock is. A stock is simply an ownership interest in a company. I have a friend who owns a large national multi-million-dollar company. He
recently told me that he just sold all of his stocks. I asked, “Why would you sell your company?” He re-plied, “What are you talking about Joe? I didn’t sell my company. It’s making record profits.” I said, “You just told me that you sold all of your stocks, and since you own stock of your company, that means you sold your company.” He replied, “That’s different. I don’t con-sider my company, stocks.” I told him, “No, it’s not different at all. It’s the same thing.”
Since November, everyone has been fixated on, The Supply Chain, COVID, Inflation, Interest Rates, The Federal Reserve, and Ukraine (all of these are, for the purpose of this illustration, the pretty girl). The first five all serious issues and the sixth a horrific human tragedy. Certainly issues to which we should all pay attention. However, occurring concomitant with these are corporate profits (the elephant). And over the past five months, corporate profits have been terrific.
The media tells us the stock market is in a bubble be-cause the S&P 500 was up 26% last year. But did you know that in 2021, profits for America’s 500 largest companies were up 59%? If company profits are up 59% but ownership value of those companies has only risen 26%, that doesn’t sound extravagant to me. And as I write this, the S&P 500 has declined 5% in the first quarter, but it looks like corporate profits will have risen 11% to 12%. In fact, while future projections are never a guaranteed thing, according to my longtime acquaintance and renowned economist Ed Yardeni (I’ve known Ed since my E.F. Hutton days in 1981), operating profits for America’s 500 largest companies (the S&P 500) should rise 13% to 15% by the time 2022 is over. On page two I have pasted a number of charts courtesy of Yardeni Research, that show long term growth of operating profits is not an unusual thing.
You don’t need to be a prophet to see future profits
I was born in 1956. Over my lifetime I have seen stamps go from 4 cents to 58 cents. I’ve seen similar increases in the cost of: bread, vegetables, tools, cars, hamburgers, milkshakes and houses. Y’all (like that southern accent? I am from south NYC you know) would probably agree that these and most other things will continue to rise in cost over the next 5 years, 10 years and 20 years. Since you agree that “things” will cost more, why is it so hard to conceive that, overall, the operating profits of the companies that make “things” will correspondingly rise? And if you would expect those profits to rise, then why not similarly expect the value of those companies to rise. Below is a chart compiled by Ed. Notice that historically, profits rise at a somewhat consistent, 7% compounded rate, with some intermittent ebbs and flows. During my lifetime, the cost of things, what we call inflation, has risen at a 4% rate. So historically, company profits over time rise at nearly twice the rate of inflation.
Since company profits tend to grow at about 7% per year, again over time, then one would presume the value of those companies should grow at a similar 7% rate. And again, with no guarantee about the future, the below chart shows that is exactly what they do. With the added bonus that just like every other business owner, people like taking some of those profits to spend now. The profits that businesses send to owners is called dividends. And the S&P 500 typically has paid dividends at a rate of about 2% per year, growing those dividends at the same 7% rate. A 7% growth in profits plus a 2% dividend rate has resulted in stock market returns averaging about 9% to 11% per year. The main difference between profit growth and share price growth has been emotions. Emotions have had little effect on operation profits, but have huge effects on share price. As you can see from Ed’s other chart below, stock prices have grown over time fairly consistently, but in the short run have had major deviations. The hardest thing for successful investing is that when it is emotionally frightening, that is the best time to add to one’s investments and when it seems the safest is when one should be most cautious. I do not know when the current emotional environment will change, but I have confidence that over time prices will rise. It’s hard to see the elephant coming, but I am confident it will eventually appear.
