the forgotten lessons of history

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is a philanthropist, investor and economist

As US equity markets trace the contours of the third great speculative bubble in history, investor confidence in a new economic era has reached extreme levels.

Among several valuation measures setting record highs is one that has reliably been a gauge for the subsequent returns and potential losses of the S&P 500 index over the following 10 to 12 years: the ratio of the market capitalisation of US non-financial companies to “gross value-added” or corporate revenues generated incrementally at each stage of production. Since early 2022, this metric has rivalled and now exceeds the peaks of both 1929 and 2000.

Across a century of market cycles, valuations have seemed least reliable precisely when they were most extreme. The only way valuations could reach the heights of 1929, 2000 and today was for the market to advance triumphantly through every lesser extreme. Yet peaks such as today’s speak volumes about future returns.

A security is nothing but a claim on some future set of cash flows that will be delivered to investors over time. Regardless of short-term outcomes, the higher the price investors pay for a given set of future cash flows, the lower the long-term return they can expect. A reliable valuation measure is simply shorthand for such an analysis.

Similar to its predecessors, this speculative episode has been accompanied by exuberant sentiment about innovation-led growth, perpetual expansion in profits, and a tendency among investors to root expectations about economic and investment prospects in optimism. As The Business Week observed in 1929: “This illusion is summed up in the phrase ‘the new era’. The phrase itself is not new. Every period of speculation rediscovers it.”

The problem is not that investors believe in a new era. Rather, the problem is the failure to recognise that the entire history of entrepreneurial capitalism is made of no substance other than the repeated succession of new eras, one upon the next, like layers of sedimentary rock, or rings in the trunk of an ancient tree.

The economist Joseph Schumpeter described this dynamic in 1928, recognising that the constant emergence of new innovations, temporarily elevated profits, and the erosion of those profits as new markets expand, is not simply a “frictional” process, but a fundamental driver of economic growth.

Because the newest layer of economic innovation is typically the most profitable, each new era is accompanied by the belief that high profit margins justify market valuations far beyond historical norms. The tendency of megacap stocks to lag the market is temporarily suspended during advances to extremes as glamour companies gain lopsided capitalisations. The persistent increase in US corporate profit margins in recent decades seems to offer some justification for this behaviour.

It may be surprising, then, that US non-financial profit margins before interest and taxes have been nearly unchanged for 70 years. The drivers of rising profit margins have been reductions in corporate tax and interest rates. Most of the impact of tax cuts was in place by the mid-1980s. Since 1990, the ratio of interest expense to gross value-added has plunged. S&P 500 operating profit margins have moved inversely to declining Baa-rated bond yields, a benchmark of corporate interest costs. A wave of debt refinancing in 2020 and 2021 has deferred the impact of the recent advance in interest rates until now. That bill is coming due.

Despite all the society-changing innovations in recent decades, real US GDP growth has averaged just 2.1 per cent annually since 2000, compared with 3.7 per cent during the preceding half-century. Without accelerated population and labour force growth, even restoring the productivity growth of the pre-2000 period would boost real GDP growth by just 0.5 percentage points annually.

Meanwhile, real US GDP currently stands 2.6 per cent above the Congressional Budget Office estimate of full-employment potential. Such gaps are common late in economic expansions, and their typical erosion over the next 2-4 years tends to be a headwind to growth. Given prevailing labour force demographics, trends in productivity and the current gap between GDP and its potential output, a reasonable baseline for four-year US real economic growth may be well below 2 per cent annually.

The latest new era is only part of an endless cycle. Extremes such as the present have been extraordinarily rare in history, and provide investors with the opportunity to examine their exposure and tolerance for risk. At such moments, it may be helpful to exchange extraordinary optimism for a calculator.