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Speaker 2:Welcome to Honest Money. I'm really excited today to have a new guest on the show, and I need him today because we're going to be talking about a very big topic and it's basically the biggest stock market in the world. Before we get into the topic, I just want to introduce Anton Aza. He is the Chief Investment Officer at 10x Investments. Anton, thanks so much for braving the podcast.
Speaker 3:Thanks, horan, great to be on.
Speaker 2:So we're talking about the US stock market today, and the reason we're talking about it is it's for a long time been the biggest driver of growth in world stock markets. There was a time when China was really helping the story for a little while, but pretty much, I feel, almost since the 1950s. If the US is doing well, then it seems to lift a lot of the other markets around the world. So it is a big market and a big factor in everything that we do. So, whether you're sitting in South Africa or in Iceland, the US market is important to you, and I think it's been especially in the last couple of years, anton. It seems to be the thing that's really lifted markets up, and now conditions are changing, and so I thought at the beginning of the year it's important to have a look at what's the US facing and what do we look at now.
Speaker 3:Yeah, horan, I mean it's incredible really what's happened in global equity markets, particularly US equities, in the last three to four decades.
Speaker 3:The size of that market has grown exponentially and it's kind of share of global equities has just continued to increase every year. I'm sure we're going to kind of get into the details of how that's happened and where that growth has come from, but I think it's useful to. So what I thought we should do is really frame this much more from a historical perspective and I'm going to throw around, if it's all right, quite a few numbers, because I think it's important that we have context of where we are. Because we have context of where we are, we can have some idea as to where we're going. So there's not going to be any stories about US growth or artificial intelligence or the role of the big seven and Microsoft, et cetera. I'm going to really try and get into the numbers quite a bit as we go through understanding where we're going, and I think that kind of frames us kind of usefully in terms of where we are right now. So should I get into that?
Speaker 2:Please do, let's kick it off.
Speaker 3:Let's get going Great, okay. So firstly I mean just looking back. Let's look at the last 10 years. You mentioned how well that market's done. Real return in the S&P 500, which are the 500 largest companies in the US, has been just over 9%. So 9.2% real returns. That's a nominal return over inflation over that last 10 years. If you take it back further, you take it back into the late 80s, so the last 33, 34 years real returns there, excluding dividends five and a half. You add dividends, you get to something like seven and a half, 8%. So it's really been an incredible three and a half decades or so of if you've owned US equities and put it in the bottom drawer and lived through that return.
Speaker 3:And 89 actually is a very useful reference point for those of you who follow US monetary policy. You'll be aware that's when Alan Greenspan took over the Federal Reserve back in the late 80s and on the back of that we've been through three and a half decades of a very different monetary system in the US and we'll unpack that a little bit when we go into the detail. But looking back to 89, and I think it's really useful to try and work out really where that growth is coming from and we've looked into this in quite a lot of detail. So if you look at that number, so the five and a half percent number that I mentioned, real earnings growth in the US in terms of S&P 500 companies has been around 3.8%. If we look at the 5.5% number, 3.8% of that comes from earnings. Then the remaining portion comes from a change in the valuation multiple. What you're now willing to pay for future earnings from a set of companies that's your multiple of earnings that you're paying to own stocks 3.8% from earnings and the remaining portion the 1.7%, coming from a change in valuation. What I'd be quite keen to do is unpack where we are now in the context of valuations and where we are now in the context of earnings relative to the last 35 years. From that we can get a feeling as to where we're going to be going forward.
Speaker 3:There's two things to point out. Firstly and this is something which I think would surprise a lot of listeners because when we think about the US, in the last 35 years, we've gone through massive transformation in technology. I think back in the late 80s was the beginning of the internet. Obviously, we fundamentally changed the way companies are run, how we live, how we communicate, and just this massive change in corporate America and how we consume. When you untangle that 3.8% US GDP is going to 2.5% and, fascinatingly wise, s&p 500 companies are top line sales after inflation has been 1.9% In an incredible 3.5 decades or so. We've actually only had below 2% growth in sales across the 500 largest companies in the US.
Speaker 3:The difference between that sales number and that number I mentioned, the 3.8% there's been a bit of a margin improvement. The biggest difference has been is two factors. Firstly, there's a massive reduction in interest costs. We went from a world of interest rates 7%, 8%, 9%, depending on if you're corporate or the government to a world in the end of 2019, 2020 where you were funding at 1% 2%. That drop in interest cost has been a big factor. The second factor, which is less known, is being the massive drop in tax rates in the US. The effective tax rate in the US went from 34% in 89% to 15% in 2019. The headline tax rate is about 21% in the US, but the effective tax rate of 15%. Those two factors interest, just simply reduction in interest costs and reduction in taxes has contributed to 40% of the earnings growth in US corporates in the last 35 years. It's been a massive tailwind for earnings growth across the US over the last three and a half decades.
Speaker 2:Just to stay there for a second. The whole economy in America has grown faster than the businesses are growing basically their revenue, but their profits are growing faster than everything. What you're saying now is that the profits are growing partly because of help from government. They're cutting tax. That's nice. I hope the South African government listens. Then, secondly, a huge change in the interest rate environment. You're saying that's 40% of the reason why the profits have been growing.
Speaker 3:Yeah, 40%. So if you look at earnings before interest in tax it's growing at 2.2%, which is below US GDP growth of 2.5% over that 32-year period that I mentioned. So yeah, it's been a huge contributor to the returns you've seen in US equities. So that's the first factor, that's the earnings piece and we'll look at that in terms of what it means from here on. But the second factor is this multiple I mentioned and just to really go into the basic share, when we talk about a multiple, let's just really simplify that and just for your listeners just understand really what a multiple is saying. It's simply saying that what is the price I'm willing to pay for a company now based on my expectation around earnings? So simplistically, company's making $100 and you have a multiple of 30, you're happy to pay $3,000 to own that company because you believe that the $100 is going to grow at a certain rate to validate the $3,000 you're paying for that company now. So your multiple changes all the time. That's what markets effectively are doing. They are repricing risk based on what they believe the value is of those future earnings. And so if you kind of break down the valuation of a market in its entirety, it's a function of current earnings, expectation of earnings and hence the multiple you're willing to pay for those earnings into the future.
Speaker 3:And the critical factor there is when you look at running what your future earnings are. You discount those earnings to today, right, and you have to use the discount rate to apply to those earnings. And the discount rate you use is the risk free rate. You might, you might, you will apply maybe some kind of a spread premium to that, but you discount that at the risk free rate. So that's the US, the US Treasury rate. So, as I mentioned earlier, with rates dropping by 6%, in this observation period that I've mentioned, from 89 to the end of 2019 to 2020, is the discount rate dropped by 6%. Real terms drop substantially and that meant that you were discounting future earnings at a lot more attractive risk free rates. And, very interestingly, there's actually a Fed paper which was produced. Fed reserve paper produced last year is 100%. So all of the change in the valuation multiple from the end of 89 to the end of 2019 is attributed to the discount reduction in the discount rate.
Speaker 3:So you know you've had this significant drop in interest rates. It's led to a significant drop in the interest costs for companies. It's also led to a significant drop in the discount rate that you apply to to owning those equities and you've had a massive reduction in taxes. And those, those or those two factors interest rates going down, taxes going down can explain the vast majority of returns in the US. When you break down the EBIT growth of 2.2% relative to a real return growth of closer to closer to six. So it's a when you just really go into those numbers, no stories, nothing around internet boom or around globalization or around you know productivity gains in terms of the labor force. If you just look at the numbers, that's those really being the two massive factors which have kind of led to such a fantastic return in the US equity market.
Speaker 2:And just to, I mean just to explain the, the, maybe not where you're going with, but the importance of this is you know, it's easy for a CEO of a company to to sell us a story about how amazing they are, and, and if they do that collectively, we all get caught up in a trap of.
Speaker 2:You know America's amazing and it's got these fantastic businesses that are becoming increasingly productive all the time and profitability is improving.
Speaker 2:And you know, new technologies are changing everything, and and what the numbers are saying is that that's all good and well, but what really drives markets and what really drives the, the price of your investments because that's what this is ultimately about is those two factors tax rates, interest rates, and and. So I'm starting to get a hint of what you're where you're leading us now, because, because the world's changed in the last couple of years around interest rates, maybe not tax rates, and and and then just one one kind of thing to just talk to you. So when we talk about, when you talk about a risk free rate, so in South Africa, for example, you know that could be the Reaper rate or the interest rate that you would get from a good government bond in the US. It's the same thing. It would have been, you know, in in a long time ago, as you're saying. It would have been, you know, 8% or 6%, and then, all of a sudden, it was very close to almost zero for a while.
Speaker 3:And and then and you've, you've purposely done it to 2020, because because then the world yeah, yeah, yeah, and I think the discussion around the equity markets a fantastic one for us to have at another time, because, in a sense, it's actually the opposite has happened, because that discount rate has actually gone up substantially. Real rates have increased here, so hence that valuation multiple in this country actually is detracted from returns over the last 10 years, but that's obviously a conversation for another podcast. But yeah, just in terms of as you left the question, the interesting point is really what's happened in the last couple of years, because as we went into COVID and through 2020, we had massive real rates which went negative in the years. They've been negative for a number of years. We went to 10 year treasuries at 50 basis points at one point at the worst time in COVID, but we had been up until the end of 2019, really almost since the financial crisis with a negative real rate, which means you're discounting your future earnings at a negative rate, which is obviously fantastic for your current valuation. And what happened? Obviously so we had 2020, we had the inflation scale in beginning in 2021, the central bank there was far behind the curve started increasing rates, as we know, in May 2022, and have been through this cycle where they've increased the Fed funds rate by over 5% over that period from the middle of 2021. Sorry, 2022. And really what happened there? That's?
Speaker 3:So we went into 2022 with a multiple. This is this multiple which I referenced. We like the Cape multiple, which kind of smooths out 10 year earnings rather than taking the current or some kind of a forecast which is the next 12 months. So what's called the cyclical adjusted PE, and the cyclical adjusted PE going into the end of 2021 was at 38. Now, just to give you a listen to some some context, 38 is in the top 1% of valuations. The only time we've had a higher valuation was back in the 99 2000 tech boom, which we will know how. That's how that ended and as we went through the interest rates hiking cycle, the markets responded in a way which was to reprice risk, just based on the factors that we've talked about. So this multiple went from 38 to 28. At the end of 2022, still, we've still very high relative to history. But what we saw in 2023, 2023 was the reversal and we saw obviously US equities did incredibly well last year, very much based on the AI hype, and that multiple went back up to back up to 33. So, even though we've had interest rates now over 5%, I mean treasuries have come come, reduced a little bit, but, you know, between four to 5% through throughout the course of last year, the multiple actually increased, which is counterintuitive.
Speaker 3:And when you think about the this point I mentioned around the higher discount rate of future earnings. So we, we, we stand here, you know, in the middle of Jan, beginning of 2024, we have a multiple, you know, around 32, 33 in US equities, which is close to the. You know it's definitely the top, top quintile, but it's, you know, right up to the top end of the range and we have, you know, yields relatively high. So our future discount rate is, is, is relatively, is, relatively high. And now let's look forward just a little bit. Let's kind of tell us what it's telling us. So, once again, just looking about returns, the two driving factors is valuations and earnings. Let's kind of just unpack earnings for a second.
Speaker 3:We talked quite a lot about the impact of interest and tax. Now, clearly, we had a high level of interest rates. All corporates are now refinancing at a higher rate with the kind of 18 months into that. Taxes really can't go any lower. Fiscal deficit in the US is, is the highest it's been outside of a, outside of the global financial crisis and COVID. So taxes going down, I mean you know they are incredibly low. Interest rates were incredibly low and are going higher.
Speaker 3:So those two tailwinds I mentioned before, at least one of them is a headwind. Another one, at best, is neutral. So you know, if you take those two and two to account, we take average earnings over the last 50, 60 years of two and a half percent. The best you can really hope for is, you know, two percent growth in terms of earnings in the US and that's a relatively optimistic view because you're not taking into account the refinancing costs. And then you apply this multiple of 33 and you take a multiple which clearly has to adjust for higher discount rates Back to some. You let's even take the average multiple an optimistic scenario of the last 30 years, because the multiple did step up to around 23. 33 goes back to normal. You have 2% Earnings growth in the US. At best you're looking at a real return and that next 10 years news equities of between 0 and 1%.
Speaker 2:Wow. So so it's not a prediction that you're making and you're using those same fundamentals and saying you know, here we are, what's driven the markets for the last 35 years. If those two Factors, which are not fashion, not productivity or technology related, to continue to be important, which which I suspect that there will be for at least another century, then we're looking at, you know, in an environment where if, if inflation gets down to, let's say, 3% in America, then we're looking at growth rates of three or 4% a Year, not above inflation, but just three or four percent a year from from the American stock market, and that's the big factor in in world markets. In other words, we're not, we shouldn't be, sitting here expecting hugely rosy growth. You know 25, 30% returns a year for the next decade. It's, it simply can't happen. What you're talking about is financial gravity. It's, you know, it's can't argue with gravity. You can, you can, you can cheat it for a little bit of time, but not for too long.
Speaker 3:That's correct. I mean, I would say one point is that is the US market is is kind of an exception, in particular a small number of stocks and within their market. But you know, you look outside of the US. You know emerging markets look more attractive, europe A little bit more attractive. South Africa, you know, definitely. So they they are, you know, in terms of how we allocate assets, you know there is definitely there are areas of the market which look a lot more attractive on that long-term basis. But you know, as you said, the S&P 500 is is, you know, between 60 to 70 percent of the of the total global equity markets and it's hugely important for the, you know, a perception of risk, the global economy and all these bits and pieces. So you know, with that type of return outlook it's it's hard to get, you know, significant above. You know, you know four or five percent real returns in multi-acid portfolios it's possible and that's obviously what we aim to do for clients.
Speaker 2:So so, anton, I'm gonna start wrapping up because we're we're, we're completely through our time and I'm gonna give you time to think about my, my favorite question to new, new guests, which is, if you were to meet yourself, with the benefit of the time and experience you've, you've developed over your career, and you could meet your 18 or 21 year old self, what would be the one lesson that you would like to impart to your younger self? And, while you're thinking about your future, takeouts for me from from this conversation. The one is you know, a lot of the time we as investors would look at the past and we would use that to project into the future. So if America's been the engine of growth from a global stock market index point of view, then and it's been certainly that for a long period of time Then it would be almost human to say, well, that must be the engine of growth for the future decade or two.
Speaker 2:And and I think the point here is, when valuations are very cheap In other markets around the world and and especially emerging markets, which have kind of really been hammered by rising interest rates in the US, then then you need to be careful of making really big one direction base, you know. In other words, putting all of your money in America based on the past could be a really big mistake For the next decade. So this is honest money. We've got to be honest with each other and say we would none of us have a cooking clue what's going to happen next week. But but we can use this weighing machine of, of, of valuations and interest rates, and and then say the best antidote to and to this kind of uncertainty is is proper diversification. So, number one globally diversify, I think, in equities. Number two don't put all of your eggs into one asset cost and put it all into cash just because interest rates are high. You know, that's that, that that never works. Over a decade it might work and you might feel really clever for six months, but over a decade probably not. And so spread your assets. Have some inequities, have some in bonds, have some in cash, you know, and and make sure that that adjusts for your tolerance for risk, your time horizons, etc. But but you know, a spread of assets is always good.
Speaker 2:And and then, don't get caught in the hype. You know, I think we kind of watch this time and time again. People get hyped up, either in excitement or in fear, you know, and they worry about Trump might come back into power and that's going to be the end of the world or whatever it is. Ai was a big thing and everyone's going to lose their jobs and new jobs when we're going to be created. And, and again.
Speaker 2:There'll be lots of reasons in the next decade to be excited or fearful, and, and and time. Time tells us that if you just stay invested and you have the proper asset mix and you properly diversified and you do nothing, you tend to do a heck of a lot better than those people that are fundamentally really active and dropping and changing their portfolios all the time. So get your mix right. Focus on the costs of your investments, make sure you've got the right mix, and and then write it out and see what happens. So, anton, I've blabbed long enough to give you time to think about the question, and so what would you do say to your younger self?
Speaker 3:So, first of all, I think the way you ended off that sentence is exactly what you described in terms of the way we think about managing money, and I've described our process in a fantastic way. I mean, I'm glad you gave me a few minutes to think about it, but I guess for me it's kind of connected to what we've been talking about. The biggest lesson I would teach myself it's a long time ago, now it's almost 30 years ago is not to be obsessed about being right, the obsession with being right and winning arguments. I wish I had learned that lesson earlier on in my life.
Speaker 3:Charlie Munger had this great perspective, which I only learned further on into my career, which was if you can't explain the alternative view as well as your own, then you don't have a good feeling for the facts and spend as much of your time on understanding the alternative views as you do on your own. And so I wish I had taught that to myself 25, 30 years ago, in terms of not only how I manage money, but how I manage my life and all the bits in business, and all the bits and pieces. So there we go.
Speaker 2:I think it's a power lesson. I mean, if you just think about the state of the world today, we're so polarized. If you're in America, you're either a Democrat or a Republican and you can't stand the other view and the other side and right across the world, in every aspect, this growing intolerance and living in echo chambers is really scary, and I think the more of us that can learn to understand the other side of a story, either we learn something from them or we become more tolerant. I think it's a great lesson. Anton Aza, chief Investment Officer at 10X Investments, thanks so much for joining us. I think that was a really good background in terms of where we've come from, where we're going, and I love it because you know, honest money is not about jargon and about forecasts. It's about expanding fundamentals and giving lessons, and that's what you've done for us. I appreciate you joining us.
Speaker 3:That's great. Thanks, Warren.
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