What’s behind this year’s buoyant market Here’s how a tepid economy and rising interest rates support a strong stock market.

What’s behind this year’s buoyant market Here’s how a tepid economy and rising interest rates support a strong stock market.

Half of that increase can be attributed to higher returns. Returns on capital affect P/E because they influence a company’s cash flow. Higher returns at a constant rate of growth and cost of capital lead to a higher P/E because a company doesn’t need to reinvest as much to continue growing. The aggregate returns on capital for the S&P 500 have increased to about 17 percent from about 12 percent over the past two decades. That increase explains about one point of the observed increase in the index’s P/E.

The other half of the increase can be attributed to the extraordinary amount of cash today’s large US-based companies are holding on their balance sheets (mostly outside the United States to avoid taxes on its repatriation). We conservatively estimate that nonfinancial US companies have at least $1.3 trillion of excess cash that is mostly invested in shorter-term government securities earning less than 1 percent, before taxes. With such a low denominator for the ratio, the effective P/E on the cash is very high. For example, if the cash earns 0.7 percent per year after tax, its price would be about 140 times its earnings. The impact of all this cash is to increase the measured P/E by another point. In other words, if companies weren’t holding all this cash, their market capitalization would be lower by about $1.3 trillion—and their earnings would be roughly the same.

The key to understanding the current record-high value of the S&P 500 is not the P/E multiple but the high level of profit margins—and that, too, requires some examination. Major shifts in the composition of the S&P 500 since the mid-1990s have led to a higher aggregate profit margin for the index. Aggregate pretax profits were stable at around 10 percent of revenues from 1970 to 1995. But since then, profit growth in the financial, IT, and pharmaceuticals and medical-products sectors has outpaced other sectors, and their margins have increased, substantially increasing their share of total corporate profits (Exhibit 1). As a result, aggregate pretax profits grew to 14 percent of revenues in 2013 and are expected to hit 15 percent in 2014.

Another, less tangible factor across all sectors is that companies may be underinvesting. For example, our recent survey found that a substantial number of executives believe their companies are passing up value-creating investment opportunities, especially in new-product and market development. If that continues, the current focus of many companies on cost cutting and short-term profits may well affect the sustainability of the market’s valuation.

http://www.mckinsey.com/insights/corporate_finance/Whats_behind_this_years_buoyant_market?cid=other-eml-alt-mip-mck-oth-1410

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