Jeremy Grantham, an astute investment strategist, recently raised doubts about American exceptionalism in such areas as health care and education. But as my Bloomberg News colleagues noted in an article about Grantham's concerns, the U.S. has managed to maintain its exceptionalism in at least one category – making money.
Corporate America has been handsomely profitable since the financial crisis that erupted in 2008, outstripping the performance of overseas competitors. The earnings per share of U.S. companies, as represented by the S&P 500 Index, have grown by 105 percent since 2008. In the developed world outside the U.S., as represented by the MSCI EAFE Index, earnings per share have grown by 30 percent over the same period. In emerging markets, as represented by the MSCI Emerging Markets Index, earnings per share have grown by 8 percent over the same period.
Such success was hardly a forgone conclusion seven years ago. At the height of the financial crisis, the survival of many U.S. companies – to say nothing of their future profitability – was in doubt. By contrast, emerging markets were lauded for their growth and comparatively low levels of debt.
Those who bet on the U.S. over the last several years have been richly rewarded. The S&P 500 Index has returned 15.3 percent annually to investors since 2009, while the MSCI EAFE Index and the MSCI Emerging Markets Index have returned 8.1 percent and 7.9 percent, respectively, over the same period.
Exceptional corporate profitability, however, does not necessarily beget more exceptional profitability. In fact, just the opposite has historically been true. Corporate profitability is a slave to the business cycle.
The following chart shows the annual return on common equity for the S&P 500 Index, the MSCI EAFE Index, and the MSCI Emerging Markets Index since 1999, the first year for which data is available for all three indexes. Even over this relatively short period, the ups and downs of the business cycle and its effect on corporate profitability are readily apparent. This implies that U.S. earnings cannot continue to grow at their current pace, and that a period of decline may be ahead.
This has practical consequences for anyone contemplating what awaits global markets. Many investors use price-to-earnings ratios to gauge market valuations, and the P/E ratio for the S&P 500 Index is 18.0. The P/E ratio for the MSCI EAFE Index is 18.8, on the other hand, and the P/E ratio for the MSCI Emerging Markets Index is 11.9.
How is it possible that the S&P 500 Index has nearly doubled the return of the MSCI EAFE Index and the MSCI Emerging Markets Index over the last seven years and yet is not more expensive? The answer is that more often than not the P/E ratio is based on current earnings. When earnings are cyclically high, as they are in the U.S., the P/E ratio appears low. Inversely, when earnings are cyclically low, as they are overseas, the P/E ratio appears high.
One way to deal with this is to smooth earnings across the business cycle. By calculating P/E ratios using ten-year trailing average earnings, the P/E ratio for the S&P 500 Index jumps to 22.7, while the P/E ratios for the MSCI EAFE Index and the MSCI Emerging Markets Index deflate to 16.6 and 10.4, respectively. Presto - a totally different story.
Smoothing earnings has another useful application. The ratio of current to ten-year trailing average earnings gives us some indication of where we are in the business cycle. A ratio greater than 1.0 implies expansion, whereas a ratio of less than 1.0 implies contraction. So where are we? The ratio for the S&P 500 Index is 1.26. The ratio for the MSCI EAFE Index is 0.88. The ratio for the MSCI Emerging Markets Index is 0.87.
This explains why the P/E ratio jumps in the U.S. and shrinks overseas when cyclically adjusted earnings are used – because U.S. earnings have grown while overseas earnings have shrunk. It also explains why the U.S. stock market has outrun overseas stock markets.
Seven years ago emerging markets were admired while the U.S. was derided. Now it’s just the opposite. Alas, the exceptional profitability of Corporate America may be fleeting.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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