Everyone with a 401(k) has been impressed by the stock market’s run-up in recent years. Even adjusting for inflation, the S&P 500 is more than 20 percent higher than its peak in the 1990 stock bubble. Of course, the economy is nearly 40 percent larger, which makes the run-up somewhat less striking.
Nonetheless, the ratio of stock prices to corporate earnings is at unusually high levels. According to data from Nobel Laureate and economist Robert Shiller, the current ratio of the S&P 500 to corporate earnings is close to 25. That compares to a long-term average of less than 15.
The reason this matters is that as the price-to-earnings ratio rises, the dividend yield falls. Forty years ago, the dividend yield was well over 4.0 percent. It currently is just over 1.8 percent. This means that more of the return from stock depends on a rise in the stock price.
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But if stocks rise just in step with the economy and profit growth (this assumes no further rise in profit shares), then capital gains are not going to be offsetting a weak dividend yield. Using the projections from the Congressional Budget Office (CBO), GDP is expected to grow at less than a 2.0 percent annual rate over the next decade. Add in a 1.8 percent dividend yield, and shareholders are looking at a real return of less than 3.8 percent.
That is considerably less than the stock returns that many investors seem to expect. Historically, real stock returns have averaged close to 7.0 percent. That has come down some in the last quarter century; if we take the period since the last peak in 2007, real returns have averaged just 5.6 percent annually. It is very difficult to see how returns, even this high, can be maintained going forward.
Stock prices could continue to outpace profit growth, but that would mean ever higher price-to-earnings ratios and ever lower dividend yields. If the market were to provide the same 5.6 percent return over the next decade, as it did since the last peak, and the growth projections prove correct, the price-to-earnings ratio will be well over 30 by 2028.
As dividend yields fall close to 1.0 percent, it would be necessary to have even more rapid increases in price-to-earnings ratios to maintain anything resembling recent or historical returns. Will price-to-earnings ratios hit 50, 60, or higher?
Well, Bitcoin has a market valuation of more than $150 billion, but most people wouldn’t want to bet on this craziness persisting for decades. The point is, in almost any plausible scenario we can anticipate, stock returns will be considerably lower in the future than in the past.
This raises a whole array of interesting questions, but I want to focus on one in particular: CEO pay. Most CEO pay comes from stock options. Rapidly rising stock prices allowed CEOs to make tens of millions of dollars, even if they turned in a mediocre performance. They just had to do something close to their peers and they could count on getting rich.
That will no longer be true in a world where stocks, on average, offer meager gains. This means that if CEOs are still going to pocket paychecks in the tens of millions of dollars annually, corporate boards will have to rewrite contracts to either give them many more options or much larger straight pay.
In a context where shareholders are not seeing the sorts of returns that make them happy, will they be anxious to rewrite contracts so that mediocre CEOs still get rich? Our corporate governance process is so corrupt that it is very difficult for shareholders to rein in the pay of their top employees, but the sight of top management getting rich while providing mediocre returns may provide sufficient motivation for shareholders to organize.
They may actually start asking questions like, “Can we get another CEO for less money who is at least as good?” And, serious downward pressure on CEO pay would be a great thing for the economy.
If CEOs were again paid 20 to 30 times the wages of ordinary workers, instead of the current 200 to 300 times, it would have an impact on pay structures throughout the economy. When the CEO gets $2-$3 million, the next line of management is just over $1 million, and the third layer is in the high six figures. This frees up a huge amount of money for everyone else.
Also, if the CEOs at the country’s largest companies are making $2-3 million, then we can expect the top executives at universities and private charities and foundations to settle for the high six figures, instead of the multi-million dollar compensation packages many now pull down. Again, less money at the top means more for everyone else.
The full impact of lower stock returns is a much longer story, but there is real potential for it placing downward pressure on CEO pay. And that is a very good thing.