The conventional wisdom today is that U.S. stock prices are high and a correction is due. But what if stock prices actually can stay elevated for a long time to come?
U.S. stock valuations have been high for longer than many expected. As Jeremy Grantham of money manager GMO shows in the chart below, the S&P 500’s average Price-Earnings ratio – or the multiple of stock prices over corporate earnings -- has been noticeably higher since 1996.
Likewise, U.S. corporate profit margins, an important determinant of stock prices, have stayed elevated over the same period (Grantham’s chart below shows the S&P 500’s return on sales):
The sustainment of high profit margins has been a bit of a mystery, but there are some good explanations for it. Foremost among them is very low interest rates – the importance of which is hard to argue with. Another is higher corporate leverage since the mid-1990s. And another is that the U.S. economy has moved from manufacturing to services, which require less capital investment and generate higher margins.
Grantham recently has suggested another factor for the mix: that growing industry concentration and monopoly-like power in the U.S. have kept margins, and stock prices, at elevated levels -- and could continue to do so for some time.
A constellation of factors – including but not limited to the regulatory environment – have helped the large and powerful become even larger and more powerful.
Typically, high profit margins attract new entrants into an industry and then get competed away to more normal levels. Conversely, low margins force participants to exit markets and help margins to correct upwards. But this dynamic doesn’t seem to have been happening the past decade. In fact, Grantham points out that the number of net new entrants into the U.S. business world has been dropping since the 1970s.
Economist Tim Harford wrote in a recent Financial Times column that we increasingly have become a “Microsoft economy" -- one where companies “pull up the drawbridge, locking in consumers and locking out competitors.” He cites a study by David Autor that found that in the U.S., manufacturing, retail, finance, services, wholesale, utilities, and transport all have become more concentrated. In each industry, the largest firms produce a larger share of output than in the past. The very largest are what Professor Autor calls “superstar firms”—companies that sell more at lower cost and higher margins and get better and better at crushing the competition (think Google, Facebook, Amazon).
There are all kinds of consequences to the domination of industry by the few. It’s not just that the handful of airlines that are left feel little compunction about treating customers poorly. Or conversely, that Amazon can create consumer heaven, but also, a competing retailer’s living hell.
It’s also – getting back to our original topic – that the stock prices of a few corporate giants can stay high for longer than we might expect. And it’s that a few gigantic stocks increasingly can drive the performance of the entire market. And it’s that investors may have to reconsider saying that an expensive stock can’t possibly go higher. In a world of industry concentration, it just might.