Why Stocks are Pricier than they Look

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My plan, Jackson, was to get my energy up. Remember I texted you a short while ago? I said I'm gonna get some coffee, and then I, I sent you a GIF of, of what?

Of, uh, Hulk Hogan.

Yeah, was that tearing the shirt off in the ring? Sort of, he sort of rallies at the last minute. Um, but what happened was I went to get a coffee and Funny twist of events, I ended up getting a big plate of spaghetti instead.

And so, so you went to a coffee shop and there was a pasta deal.

I don't want to get into all the details, but Hulkamania is not quite running wild yet. It's more of like a King Kong Bundy situation. King Kong Bundy: The Retirement Years kind of situation, but it's all upside from here. We're gonna be talking about our favorite topic, the stock market. It was down 9% at one point from its January high. This was a, a buy the dip opportunity, would you say? And, and it seems like the market took it for that because it has rocketed right back for a couple of days. It's, it's, it's already bounced back several percent. Did you buy the dip, Jackson?

I've just been buying every month, so I, I actually missed the dip.

You're just being a normal judicious saver and putting money in Regularly.

And if it, if it was on the end of the month instead of the beginning, I would've lucked out this time. But, but who knows?

I want to talk on this episode about what I call buy the dip-itis. And I want to give a look at just how expensive the US stock market is, where we stand, because I think there are a handful of distortions right now. I think the stock market is actually considerably more expensive than it looks, and I'll explain why. We're not going to have a guest this episode. This is going to be, uh, this is going to be what an editor of mine some years ago used to call a Jack Howe talker. Only here, only here is actual talking instead of writing.

Isn't that every podcast? Isn't that a podcast?

I guess so. I'm a little worried that the topic isn't super audio friendly. I'm supposed to talk about it on television later this week, and I don't think it's TV friendly either. You could tell a TV-friendly topic, you know, on TV when, when people are talking about something, they run what's called B-roll.

Oh yeah. You know, shots of people shopping or filling up their gas tanks like that.

Yeah.

Sort of thing.

Like they used to say Americans have gotten heavier again and then they would show people from the neck down. Like, I don't mean, I don't mean to laugh, like walking around a shopping center and like eating ice cream cones. And I used to— it tells you immediately what the story is about. And I used to think to myself, do these people know? Do they recognize themselves on TV? Because a life goal of mine, you know, I'd put on a few pounds over the years. A life goal of mine is to not end up as B-roll in a, in a news item about Americans gaining weight. That's— I'm shooting for that anyhow.

Yeah. Next, next time you're at the mall and you see someone from a TV station holding a camera like waist high, Just run away.

Okay, well, I don't know what the B-roll would be for this item, but we're going to talk about some topics like free cash flow and corporate profit margins and the federal deficit and the big AI spending spree. By the way, I should mention this is the Barron's Streetwise Podcast. My name is Jack Howe. Listening in is our audio producer, Jackson Cantrell.

Hi everybody.

There's that energy. See, I can feel it already.

I was just trying that one out. I was trying that one out.

Let me start you off with some numbers. The reason the stock market has been wobbling this year, there are two key reasons. One is what I'll call artificial intelligence angst. Companies are spending all this money and investors are worried about whether the spending is wise and whether it's sustainable. And we'll come to that. And the other one is a crude oil spike that's related, of course, to the war in Iran and the latest bounce back we've had at the time of this recording that's related to maybe investors' perception that the war in Iran might wind down sometime soon. But it's a situation that's very much in flux. But in the backdrop of all this has been really an excellent trend for US company earnings. If you look at the S&P 500 index, the earnings estimate for this year, it's been rising. The latest number implies a growth rate this year of 17%. That's much higher than usual. And so the result, if you have an S&P 500 that dipped a little bit in price and you have earnings growth that's excellent going forward, You have a stock market that was recently trading at a price-to-earnings ratio, a forward price-to-earnings ratio. In other words, using estimates for the year ahead starting now, it was recently about 20, and that's down from over 23 last fall. And it's merely a 20% premium to the market's two-decade average. I say merely, 20% is, you know, a decent-sized premium. But it's not wacky. I think you have to be careful with that math. However, investors should beware buy-the-dip-itis. That's what I call a condition that can lead to novice and even experienced investors who've been treated to these wonderful returns over the past decade and who have not seen a bear market that took longer than a year to recover since the one that ended March 2009. It can cause them to pile on risk whenever the stock market hiccups, like recently. As I'm going to explain, there are reasons to believe that the stock market is really more than 35% pricier than usual, maybe significantly more. There's a confluence of factors that have puffed up profits and flattered comparisons, and I'm going to run through 3. None of these, I'll tell you upfront, are deal breakers, and this is not a call to flee stocks. I just want investors to recalibrate their expectations and maybe bolster their resilience. I'll say more on that in just a bit. Are we ready, Jackson, to look at the first of 3 factors?

I'm ready.

Here's what we'll do. I'll run through these quickly. We'll get through the first one, then we'll take a break, then we'll do the last 2.

Sounds like a plan.

You don't sound like you believe me on the quickly part. Let's, let's see what happens. The first factor has to do with free cash flow. I'll call it follow the cash. 2 years ago, there were 9 Wall Street analysts who had ventured estimates of the free cash flow that Amazon would generate by this year, 2026, and those estimates ranged from $76 billion to $126 billion. and the average was $105 billion. I know big numbers like this can all kind of blend together sometimes, but that is a staggering amount. It has been reached only by 2 companies ever. One of them is Apple, and the other is the oil monopoly of Saudi Arabia. But if you look today, the 2026 consensus estimate for Amazon's free cash flow stands at $11 billion, and it's actually not free cash flow, it's cash burn. So how does a company go from plus $105 to negative $11 billion? It's definitely not because Amazon has fallen on hard times. It has decided to go all in, of course, on building AI computing power as quickly as possible. And it's not alone. Alphabet, Meta, Microsoft, and others are spending astonishing sums. And you have heard discussions about whether all of this spending is wise. I think you can safely look at a company like Amazon, which already does this lucrative business in building computing power and then renting it out. For a company like Meta, which does not sell cloud computing, it might be more of a leap. But that uncertainty about how and when this spending will pay off is part of why all of these stocks that I just mentioned are down this year. Well, let's put aside the merits of the spending, though. I want to focus instead on the accounting. When companies spend money on, let's say, salaries and advertising, electricity, that gets deducted from their sales right away for purposes of calculating their earnings. But big-ticket purchases like new data centers and equipment, those go into a special category, and it's called capital expenditures, or CapEx for short. CapEx does not get deducted from earnings right away. It gets deducted little by little over years. The idea, what accountants are trying to do is to simulate for investors how that spending would have matched up with revenues if it had happened gradually over the projected useful life of the stuff being bought. It's called the matching principle, and it's at the heart of earnings accounting. Okay, hold on to that thought. It's difficult to overstate the scale of the current CapEx spree. Let's put it this way: Barclays, which is something of an AI bull lately, predicts that combined CapEx for hyperscale players like these will peak at $1 trillion by 2028. $1 trillion. For comparison, as recently as 2023, all of the companies in the S&P 500 combined had earnings of $1.9 trillion. If you look now, those earnings are shooting higher. The estimate for this year is $2.8 trillion. Remember, those earnings, they mostly don't subtract for all the spending that qualifies as CapEx. But here's the key. Earnings definitely do count all of the winnings for the companies that are on the receiving end of that CapEx spending. NVIDIA, the AI chip king, It will likely turn the biggest corporate profit in history in its current fiscal year ending next January. The latest estimate I saw was $200 billion. $200 billion. Until 3 years ago, this company had never earned more than $10 billion in a single year. There are other data center arms dealers whose earnings have suddenly multiplied. They include Micron Technologies, a memory maker. It's expected to make $66 billion this year. That's the 5th largest contribution to the S&P 500's total. And the chip designer Broadcom, $56 billion. That's the 9th largest contribution. So one question investors should ask themselves on behalf of companies receiving all this money is how sustainable the spending seems. But at the very least, I think investors ought to make sure that this money is sort of counted fairly when they're sizing up the market. Earnings don't really do that right now. If you want to do that, you should look at free cash flow. Unlike earnings, free cash flow is not a measure that companies are required to report on their financial statements, although many volunteer it in their slide decks and press releases. It's easy to calculate. You start with the actual cash that's generated from operating activities, and then you fully subtract CapEx. So free cash flow for the S&P 500 is pegged at just under $1.9 trillion for this year. That's nearly a trillion dollars short of earnings. It's pretty common for the two measures to differ, but definitely not by this much. So remember I said that if you look at earnings and the price-to-earnings ratio of around 20, that the S&P 500 is around 20% more expensive than usual based on the past two decades. What if we look instead at free cash flow? And the price-to-free cash flow ratio. That's 27.5, and it makes the S&P 500 38% more expensive than usual versus the same two decades. I think with earnings, you're only getting half the story on all that AI spending, and it's the good half. I think with free cash flow right now, you're getting a fairer picture, and it doesn't make the stock market look especially cheap. So that's factor one. I hope it makes sense for everyone. Basically, you have these colossal tech companies in the S&P 500 spending unheard of sums, more than $100 billion apiece, and they're spending that money with other companies in the S&P 500. And we're counting the money for the companies receiving it, but we're not counting it for the companies spending it. And it's making the stock market look cheaper than it really is, especially now.

Yeah, so you have all these big companies spending money on data centers, what happens if they stop? Like what, what's the effect on the market if they keep spending versus say, they say, you know what, we've built up our infrastructure and we're gonna take back that free cash flow now.

It's an excellent question. If they suddenly pulled back on that spending, the effect on their own earnings would be not much because earnings mostly isn't counting the CapEx to begin with. The effect on their free cash flow would be humongous. Many of these companies would suddenly begin generating more than $100 billion a year, but that's not going to help S&P 500 earnings. What would happen is that the companies on the receiving end of that money would stop receiving it, and that would tank earnings for them. And since they're so heavily weighted in the index, it would probably impair earnings growth for the index, if not drive earnings lower. And since I think a lot of investor optimism is based on the growth rates that we're seeing, you'd have to believe that investors would take down the stock market's price. I'm not predicting that that's going to happen right away. And again, this is not a bearish call for the stock market from here. I'll come later to what to expect from the stock market from here. I'm just saying, if you're someone who normally has 70% of your money in stocks, It's been almost a couple decades since we've had a long bear market. I would resist the temptation to have this view that, hey, the market always bounces back quickly. We just had a 9% dip in stocks. Let me take my allocation up to 90%. If you're supposed to be at 70%, stay at 70%, but don't go a lot lower than that either. I'll come to that too. Let's take a quick break here. While you're waiting, you can play some mental B-roll of, uh, of what Jackson is doing during the break. I can tell you based on what I'm seeing now, he's got a guitar hanging on the wall behind him. He's smiling. He's got quite a head of hair, Jackson does. Don't, don't feel like you have to return the compliment, Jackson.

You got some hair. It's close cropped.

That's a number 1 with the clippers.

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Welcome back, Jackson. I want you to look out my window here. I have two— I'll call them stately turkeys. They're just walking across the yard like they own the place.

I didn't know wild turkeys could look menacing.

Yeah, they can.

Yeah, the, the, it could have been our national bird, the wild turkey.

The turkey. Ben Franklin. Yeah, I think he's right. You know, the turkey is, um, that's a noble enough bird and you could eat it. To me, that's a plus. Maybe to someone else it's a minus. Maybe being able to eat a bird takes away from its nobility. I don't know how that scores.

Yeah, yeah, the bald eagle wings aren't as savory.

Definitely not. Although, would you go buffalo or teriyaki? You know what, don't answer that. Don't answer that. It's disrespectful. We're talking about, uh, not wings. We're talking about the U.S. stock market and buy the dip-itis and why the stock market is maybe more expensive than it appears. And I gave you one reason before the break, and that's that free cash flow, which fairly subtracts for all that spending for AI, it's not nearly as generous to the stock market as earnings are now. Let me quickly run through two more factors and then I'll give you some final thoughts. That almost sounds like the name of a segment, right? Final parting, some parting shots. I'll give you some stuff that I say before I stop saying stuff.

You better trademark that before it's taken.

We move now to what I'll call marvelous margins. I'm gonna make some comparisons here between now and the 4 decades that ran through 2000. Those decades didn't include a lot of the froth that we've seen in recent decades. Okay, so when you look at the 4 decades through 2000, profit margins for the S&P 500— that's earnings as a percentage of revenue— they averaged 5.3%. They topped 7% only once, and that was around when the dot-com stock bubble peaked in 2000. So based on that period, you'd call 5% normal and 7% the top end. But today, profit margin is over 12%. And that's not just AI money. Margins were roughly this high back in 2021. That was before the world had heard of ChatGPT. There are several reasons at work here. One of the most important is that the economy since the 1980s has grown less weighted in heavy industry and more weighted in technology, which has brought structurally higher margins. Much of this profitability surge might be long-lasting, maybe even permanent, but there are signs that should give investors pause. There is a measure of the economy called gross domestic income. You might be thinking, do I mean gross domestic product? Well, the two are almost the same except Gross domestic income tallies income instead of spending. It's a way to get an idea of the size of the economy. And the largest contribution by far to GDI is worker compensation. It makes up most of GDI. Corporate profits make up only a sliver. But the mix has shifted, and I think the shift has been notable. Over those 4 decades to 2000, worker compensation averaged 56.4% of GDI. It rarely dipped below 55%, but the latest reading we have is 51.9%, so it's several percentage points down from what used to be normal. The story is just the opposite for corporate profits before tax. Don't worry about the taxes, I'll come to them soon. Corporate profits averaged 8.1% of GDI over those 4 decades, but they've now surged to 11.5%. This is not me subtly raising my picket sign and saying, give workers a raise. I'll leave it to others to opine on what's the right split of the pie for workers and corporations. I mean, all of you listening deserve a raise, just between us. You're doing fantastic. My focus here is on investor returns. So let's just point out the obvious. The workers are also the customers. If they're doing less well than they used to, we might expect to see consumer spending suffer. It hasn't really suffered. It's doing fine. Some economists find evidence of a so-called K-shaped economy. We've talked about that. The two legs of the K represent different income groups. A relatively small slice of high earners might be boosting spending growth. Other economists note that credit card debt for low earners has been rising. I just want to point out that if it's true that the rich are propping up the economy, we should all give a thought to what's called the wealth effect. That's the tendency of consumers to spend more when their stock and house values are riding high. They are, as I mentioned, even after the S&P 500's recent dip, if you want to call it that. The return over the past 10 years has been stupendous. 273%. That's more than 14% a year. The average return for stocks over long time periods, not counting inflation, is around 10%. House prices have shot up to the Case-Shiller index of U.S. home prices is up 87% in a decade. That's about 6.5% a year. The normal price increase for houses, I've long argued, should be equal to the rate of inflation over the past 10 years. That was 3.3% a year. So houses have done twice as well as inflation. Whatever level of profit margin is normal for companies now, The current one is almost certainly benefiting from a wealth effect, and that's flattering valuations. The problem is that the wealth effect works in reverse too. Big sudden price drops for the overall housing market are rare, but they're not unheard of. Remember, that was what set off the last long bear market that ended in 2009. Big drops for the stock market, on the other hand, are fairly common. We tend to think of the stock market as following the economy, but sometimes it can lead the economy. That's what might be happening now, and it could be artificially boosting earnings and lowering that price-to-earnings ratio. Jackson, any questions before we move on to the last and final factor?

Well, you got super political and I'm outraged.

I'm sorry about that, Jackson. I won't ask you which direction you're outraged in. I like when I get two comments and they're outraged in opposing directions politically. It makes me feel— it makes me feel like I really found the middle.

There's no winning.

The last factor, I don't know what you want to call it. Let's label it the helping hand of government with a question mark. You will surely not be surprised to learn that the federal government will spend much, much more money than it collects in taxes this year. It did so actually for much of the 4 decades to 2000. The deficits averaged 2% of GDP per year. But this year's shortfall is estimated at 5.8%, rising to 6.7% in a decade. That is emergency-level spending, only it's without the emergency and there's no end in sight. These deficits, of course, have accumulated into a monstrous debt And we've been hearing dire warnings about it for decades. You have to say there hasn't been much impact on interest rates or investor returns. So, why worry now? There are a lot of reasons I can think of, but I'm going to give you two. One is that Social Security's trust fund is expected to run dry in 2032, just 6 years from now. So, either benefits will have to be cut by then or taxes will have to be raised.

Why can't they just borrow more money like they do with everything else?

Well, Social Security is supposed to be its own thing. That's why you have a trust fund. Of course, you could argue that the trust fund isn't really doing its job right now. So who knows, maybe at some point they will. But that brings me to the second item on the deficits that I want to mention. It's about all this general borrowing. In recent years, the U.S. government has been borrowing at interest rates that exceed the nominal GDP growth rate. That's bad. The numbers don't work. You can think of it like a saver borrowing money at 5% in order to buy a 3% certificate of deposit. Not a good idea. But that's only happening now with some of the debt. Starting in 2031, it will begin happening with the overall debt. The interest rate on the entire debt will exceed the growth rate. Permanently and increasingly. The period beyond that is what economists refer to as a debt spiral.

Doesn't sound good.

I think it's one of the worst spirals. I mean, spiral— if spiral ham is the best and an airplane spiraling out of control is all the way at the bottom, then I'll say debt spiral is second to worst on the spiral scale. Okay, so what's noteworthy about both of these things that I just mentioned is they both happen within the next 6 years. US senators serve 6-year terms, which means we've reached the point where some of the people in charge are still going to be around to own the mess. And maybe that doesn't matter, but maybe it does. You know, Congress has two choices here. They could do something or they could do nothing. And based on recent history, it's tempting to bet on nothing, but I think that's becoming increasingly difficult. Why is this the last of my three factors? One thing about those massive deficits is they're stimulative to the economy and earnings, at least for a while. It's like a credit card advance on growth. The money trickles through the economy. Some of it ends up accruing to the bottom lines of big publicly traded companies. If we tackle deficits, whether it's through slashing spending or raising taxes, and there are very strong arguments for doing so, It would have the opposite effect. It would dampen growth and earnings, might even bring down company earnings more directly. Corporate taxes averaged 35% of profits over those 4 decades to 2000. We were recently around 20%. If you say, let's go back to where it was and you raise taxes, of course it leaves companies less profitable and stocks looking more expensive. These are difficult choices and we're quickly approaching a point where we can't just wait. That's it for my 3 factors. Jackson, you want to pull down that guitar off the wall and play something inspiring while I move into the finish?

I gotta work on my chords first.

Isn't it like, don't you only need to know 3 and you could play like a million songs? You probably need an A and a— the most— I feel like G is a G, an important one. I'll say a G and A and a— give me another, give me one more letter. How's a B? Does a B do anything for you?

You'd say C, but But it's more about the distance between the courts. It's a 1-4-5 progression is what you're looking for.

Let's just end with what not to do as an investor. There's good news here in that high valuation for stocks have historically been a poor predictor of returns over the following year. In other words, a pricey market can and often does move higher. The bad news is that valuations have been a much stronger predictor over the subsequent 10 years. So investors should count on only modest returns from here for the coming decade when they're doing their planning. Here's where you normally hear financial salespeople or advice givers present some miracle asset class that can reliably juice your returns without adding to your risk, except those don't really exist. The only thing they tend to reliably add are fees. The answers are ugly and unpopular. Spend less, save harder. Be prepared to work longer. Uh, sorry, Jackson, that one hit home. I don't mean work longer today. I mean, you know, career-wise. Don't go all in on stocks and definitely don't go all out. When deficits are unsustainable and lawmakers are kind of feeble as now, one of the likeliest paths forward is to simply run inflation hot until the debt becomes worthless. That's worth less— two separate words, not worthless, one word. That can be bad for stocks in the near term, but over decades, companies that make and sell valuable things, that's the best vehicle for beating inflation. Stick with American stocks for the clever tech and the cheap domestic energy, and stick with overseas stocks for the lower valuation and the currency hedge. And since it's been a while, I'm going to leave you with a reminder about long bear markets. The truly nasty thing about them is that they tend to pull the economy down with them. An investing novice will say that the market always comes back. A veteran will say, yes, it does. But when your stocks crash, the probability of losing your job goes up too. That means you'd better have a cash stockpile or a stream of investment income to lean on, or you'll end up selling stocks low. Right now, ordinary money market funds and dividend-focused stock funds both pay close to 3.5%. Safe short-term bonds are closer to 4%. That compares with just 1% for the S&P 500's dividend yield. So have a cash stockpile, have some investment income if you can. Here's hoping that the next long bear market is far off, but the best time to prepare for it is now. That's where you go from a G to an A to a pleasing B. Would that, would that be pleasing? Probably not pleasing. I don't actually know what these chords sound like. So that did— that pleased— that pleased me.

Yeah. Yeah.

It worked. I want to thank absolutely no one except our audio producer, of course, Jackson Cantrell. If you have a question for us about investing, you can send it in. We might play it and answer it on a future podcast. Just tape it on the voice memo app on your phone and send it to jack.hough@barons.com. Subscribe, leave a comment, the whole thing, and have a great week. We'll see you soon.

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