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#224: Where is the Growth Coming From? (part 2)

#224: Where is the Growth Coming From? (part 2)

micksonmatch
February 03, 2025

S2N Spotlight

On Friday, I wrote about how the S&P 500 returns are far outpacing the growth of the earnings of the underlying companies and that the earnings themselves are somewhat limited in their ability to grow above the average of the economy as reflected by GDP. There were a few errors in the chart I prepared on Friday, so this is an improved and corrected version.

I got a number of questions and comments from the letter; there was already something pretty obvious running through my head that I wanted to add to the chart, so I am going to present a variation of the above chart that might help explain some things.

But before I do that, one of our subscribers commented that this is precisely what Buffet is concerned about.

Buffett has expressed concern about situations where stock performance becomes “uncoupled from the plodding performances of the businesses themselves.”. This reflects the idea that stock prices can’t indefinitely outpace the growth of the underlying businesses and economy.

Buffett has warned that when corporate valuations significantly surpass GDP, it may indicate that these companies are not generating sufficient real economic value to justify their market prices. He likens it to “playing with fire.”. I wasn’t able to get the data I wanted to produce a chart, but the current state is:

The market Capitalisation of the S&P500 is over $50 trillion.

The current US GDP for 2024 was $30 trillion.

According to the Buffet Indicator, we are at a ratio of 1.66

No wonder Buffet’s Berkshire Hathaway has sold so many assets and is sitting on a pile of cash that would make a country president weak at the knees.

One of the ways that one can achieve the growth in the stock markets as evidenced in the above chart above the earnings growth is through the use of leverage. This too has its own limitations but can certainly do the trick for a long time.

The chart below is what I think is happening under the surface and hasn’t been fully appreciated until the current bout of inflation. In the chart below, I have created a constant 2024 dollar by deflating earnings and the stock market returns by inflation. What you achieve is a much closer stock market return to the earnings return.

To sum up, the stock market should only grow over the long term in line with its earnings growth. Companies earnings should only grow in line with the country’s economic growth, all things being equal. However, we see much more growth in the stock market than what we would anticipate. In my latest chart, I believe we see a big culprit is the effect of inflation.

S2N Observations

A reader explained why this EURUSD forward curve is upward sloping despite the fact that the EURO’s interest rates are lower than the US. It turns out I did not know how to calculate the forward curve. My chart is right but my understanding was wrong.

The forward curve is not a prediction of what the currency, in this case the EURUSD, is going to do. It is doing what is called Covered Interest Rate Parity. The idea behind the forward curve in currencies is to eliminate arbitrage so that an investor could profit from borrowing in one currency and investing in the other. Because interest rates are higher in the US and will therefore yield more interest it has to make the price of the forward EURUSD higher to offset the arbitrage.

If your head hurt, so did mine trying to absorb and explain it. As we know, there is no such thing as a free lunch, so don’t be surprised by this curve not telling the future price action of the currency.

There is so much to say about tariffs, and our heads already hurt. We will talk about it another time, but its clear Trump has fired the first shots as he promised, and this is about to get quite messy.

Speaking of sore heads, I am not sure if mine is from the lack of caffeine or the price of caffeine. We are witnessing another new ATH.