CURVE APPEAL

Wealth ac­cum­la­tion is ex­pected to slow down in the fu­ture

National Post (Latest Edition) - Financial Post Magazine - - CONTENTS - >BY ARTHUR SALZER Arthur Salzer is CEO and chief in­vest­ment of­fi­cer at North­land Wealth Man­age­ment.

Why ac­cu­mu­lat­ing wealth will slow down com­pared to the past 35 years.

EVENTS SUCH AS BLACK MON­DAY in 1987 (the largest one­day price de­cline in the eq­uity mar­ket), the Asian Cri­sis in 1997, the dot-com crash of 2000 and the Great Re­ces­sion in 2008 sure put the fear into in­vestors, but both bond and eq­uity mar­kets have gen­er­ally been ex­tremely re­ward­ing for the past 35 years. Get ready for that to change. The next 20 years will not be like the last, ac­cord­ing to Di­min­ish­ing Re­turns: Why In­vestors May Need to Lower Their Ex­pec­ta­tions, a report by McKin­sey Global In­sti­tute, the global man­age­ment con­sult­ing gi­ant.

If McKin­sey is cor­rect, and re­turns are in­deed di­min­ished for an ex­tended pe­riod in the fu­ture, it ap­pears that the growth of wealth will slow com­pared to the past three and a half decades. The im­pli­ca­tions, while not yet dire, could prove to be prob­lem­atic for Baby Boomers as they be­gin to re­tire over the next five years in greater num­bers. In­di­vid­ual re­tire­ment sav­ings will clearly be af­fected, but pri­vate and pub­lic pen­sion funds may also have sig­nif­i­cant difficulty meet­ing their obli­ga­tions as re­tirees be­gin to draw on their pen­sions.

As a primer for those who aren’t econ­omy wonks, there are five principal variables that drive the eq­uity mar­ket: cor­po­rate prof­its as a per­cent­age of GDP; the growth rate of cor­po­rate prof­its; the growth rate of earn­ings per share; the level of in­ter­est rates; and the mag­ni­tude of stock re­pur­chases by firms. With the ex­cep­tion of in­ter­est rates, the higher the value of each fac­tor, the higher the level the eq­uity mar­ket will be.

One of the most in­flu­en­tial and eas­i­est fac­tors for in­vestors to ob­serve is the cur­rent in­ter­est rate. In gen­eral, the lower that cur­rent in­ter­est rates are, the higher val­u­a­tions of stocks should be. Since 1981, we have had a non-stop col­lapse in in­ter­est rates, which con­trasts sharply with the ris­ing in­ter­est rates seen from 1962 un­til 1980. Suf­fice to say, with in­ter­est rates de­clin­ing from al­most 18% to near or be­low zero, the cur­rent price/earn­ings mul­ti­ple on stocks is likely fairly val­ued. How­ever, if rates were to rise, then mul­ti­ples will de­cline.

The growth of earn­ings has played a sig­nif­i­cant role in boost­ing re­turns as well. Since the 1980s, the share of na­tional in­come go­ing to cap­i­tal (prof­its) at the ex­pense of labour has in­creased to nearly 43% from 35%. This trend has been a pos­i­tive for in­vestors, but given the cur­rent slow-growth eco­nomic en­vi­ron­ment, this may not likely con­tinue as the mid­dle-class who feel dis­en­fran­chised have been call­ing for wealth taxes.

Since 2000, cor­po­rate prof­its as a per­cent­age of GDP have been steadily climb­ing in tan­dem with earn­ings. Rel­a­tive to the past al­most seven decades, this level is at an all-time high. Fu­ture gains, al­though pos­si­ble, are limited, with the likely di­rec­tion head­ing down.

Mean­while, earn­ings per share of the broad mar­ket in­di­ca­tor, the S&P 500, are now ap­proach­ing US$125. The rise in EPS is an im­por­tant driver of the stock mar­ket since it rep­re­sents the E in the P/E mul­ti­ple. One rea­son for the rise in EPS has been the in­crease in cor­po­rate prof­its, but another is the ef­fect of large cor­po­rate stock re­pur­chases, which have ex­ploded in num­ber dur­ing the past cou­ple of decades. Changes to ex­ec­u­tive com­pen­sa­tion in the mid-1990s have en­cour­aged CEOs to fo­cus on share price ap­pre­ci­a­tion over other met­rics and net buy­backs have played a sig­nif­i­cant role in push­ing EPS higher.

All five fun­da­men­tal driv­ers played a pos­i­tive role in push­ing stock-mar­ket val­u­a­tions higher. But go­ing for­ward, these tail­winds will likely be­come head­winds. Pri­vate and pub­lic pen­sions may have sig­nif­i­cant difficulty meet­ing their obli­ga­tions

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