The Single Greatest Predictor of Future Stock Market Returns
original source: http://www.philosophicaleconomics.com/2013/12/the-single-greatest-predictor-of-future-stock-market-returns/
Consider the following chart, which shows the average investor
portfolio allocation to equities from January 1952 to December 2013:
The metric in this chart takes no
input from any variables traditionally associated with valuation:
earnings, book values, profit margins, discount rates, etc. It consists
only of a simple ratio between two numbers that can easily be
calculated in FRED. Yet, as a predictor of future stock market
returns,
it dramatically outperforms all other stock market valuation metrics
commonly cited.
In this piece, I’m going to do five things. First, I’m going to
explain, in very simple terms, the accounting principles behind the
metric. The explanation will include instructions (with ready-made
links) for how to graph the metric in FRED. Second, I’m going to
discuss the dynamics of asset supply, with a special focus on equities.
Third, I’m going to challenge the conventional framework for
understanding the relationship between valuation and stock market
returns. Fourth, I’m going to introduce a new framework, one that
relates stock market returns to equity asset supply. Fifth, I’m going
to present a scatterplot of the predictive performance of the metric
alongside other metrics, and discuss what the metric is currently
forecasting for U.S. equity returns. I’m going to conclude by briefly
touching on the question of whether or not the current U.S. stock market
is “overvalued.”
Accounting Principles: Cash, Bonds, Stocks
To begin, let’s arbitrarily divide the
universe of financial assets into three categories: (1) cash, (2)
bonds, and (3) stocks. By “cash”, I mean bank deposits and circulating
currency. By “bonds”, I mean any certificate of obligation to repay
borrowed cash–commercial paper, bills, notes, bonds, etc. By “stocks”
(or “equity”), I mean shares of ownership in a corporation (public or
private). Note that these definitions are intentional simplifications.
Financial markets function on the following principle. For
every unit of every financial asset in existence, some investor
somewhere must willingly hold that unit in a portfolio at all times. By
“investor”, I mean whoever owns wealth. There are intermediaries–hedge
funds, mutual funds, pension funds, financial advisors, etc.–that help
investors allocate wealth. But these entities are not the actual
investors–their clients are.
The financial market is the place where investors decide–via
trades–who will hold what units of what assets. Note that cash, as an
asset, is special in that respect. It is the medium through which
trades occur. Investors can only switch from one stock or bond to
another stock or bond by going through cash. The going rate of exchange
(bid or offered) between a unit of an asset and cash is the market
price of the asset.
At the margin, if no investor can be found that wants to hold a given
unit of a given asset at the prevailing market price, then the market
price will fall until a willing holder is found. With respect to shares
of a stock or bond, the application is straightforward. If no one
wants to hold a given share at $100, then we try $95. Still no takers?
Then we try $90, then $85, then $80, and so on. We continue until some
investor emerges that finds the share sufficiently attractive to hold
at the offered price. The concept applies analogously to cash–if no
investor wants to hold cash, then the price that is bid on everything
else will rise until everything else becomes so expensive and
unattractive that some investor somewhere capitulates and agrees to hold
cash instead. Measured in terms of other assets, the price of cash
falls.
The “supply” of an asset is the total market value of it in
existence–the total number of outstanding units times the market price
of each unit. Put differently, supply is the amount of the asset
available to be held in investor portfolios–the amount available for
investors to allocate their wealth into. In aggregate, investors have
to want to hold the total supply of each asset in existence in their
portfolios. If there is too much supply of a given asset relative to
the amount that investors want to hold in their portfolios, then the the
market price of the asset will fall, and therefore the supply will
fall. If there is too little supply of a given asset relative to the
amount that investors want to hold in their portfolios, then the market
price will rise, and therefore the supply will rise. Obviously, since
the market price of cash is always unity, $1 for $1, its supply can only
change in relative terms, relative to the supply of other assets.
The Aggregate Investor Allocation to Equities
Now, suppose that we open up every
investor’s portfolio and calculate, for each investor, his percent
allocation to stocks, bonds, and cash. My portfolio might be allocated
85% to stocks, 15% to bonds, 0% to cash. Yours might be allocated 50%
to stocks, 20% to bonds, 30% to cash. And so on.
The question we want to answer is this: what would the
average
of all of these investors’ portfolio allocations look like, weighted by
size? More specifically, what would the average investor allocation to
stocks be? And how would that average compare to the averages of the
past? It turns out that this question predicts the market’s future
long-term returns better than any other classic valuation metrics to
date developed–price to earnings (P/E), price to book (P/B), price to
sales (P/S), CAPE, q-ratio, Market Cap to GDP, Fed Model, etc.
To answer the question, we need to know two things: (1) the total
amount of stocks that investors in aggregate are holding, and (2) the
total amount of cash and bonds that investors in aggregate are holding.
Mathematically, the total amount of stocks that investors are holding
divided by the total amount of everything (stocks plus bonds and cash)
that they are holding just
is the
average investor allocation to stocks.
Now, to calculate the total quantity
of cash and bonds in investor portfolios, we might think that we can
just sum the total quantity of cash and bonds in existence outright–the
total amount floating around the economy. After all, these securities
have to be held by investors. But this approach won’t work. The reason
is that a large portion of the bonds in existence are actually held by
banks, not by investors. This fact extends to the central bank (the
Federal Reserve), which presently owns an unusually large quantity of
bonds.
Fortunately, there’s a convenient way to get around the problem.
Recall that when the Federal Reserve buys bonds (treasury, MBS, etc.),
it doesn’t add any net financial assets to investor portfolios. Rather,
it takes bonds out of investor portfolios, and puts newly created cash
into investor portfolios. It changes the cash-bond
mix of the assets that investors hold–but not the total amount.
It turns out that private banks do essentially the same thing when
they buy assets. They take the assets out of the hands of investors,
and put their own liabilities–in the form of their own bonds or deposits
(cash)–into investor hands. (They can also fund purchases with equity
sales, but the equity component of a banks balance sheet is small enough
to ignore.)
The entities that create net new financial assets (that investors can
hold) are not banks, which are just intermediaries, but rather real
economic borrowers. The universe of real economic borrowers consists of
five categories: Households, Non-Financial Corporations, State and
Local Governments, the Federal Government, and the Rest of the World.
When these entities borrow directly from investors, the investors get
new bonds to hold. When the entities borrow from banks, the investors
get new cash to hold. That’s because when a bank makes a loan, the
money supply expands. The loan creates a new deposit that didn’t
previously exist–some investor must now hold that deposit in his
portfolio of assets.
It follows, then, that if we want to get an estimate of the total
amount of bonds and cash that investors are holding at any given time,
all we have to do is sum the total outstanding liabilities of each of
the five categories of real economic borrowers. Those liabilities
either translate into cash that an investor somewhere is holding (if the
entity took a loan from a bank, which expands the money supply), or
they translate into a bond that an investor somewhere is holding (if the
entity borrowed directly from the investor). Note that the average
bond trades close to par (with some above, and some below), so, in
aggregate, the value of the liabilities approximates the total market
value of the bonds.
Banks don’t generally hold stocks. So to estimate the total amount
of stocks in investor portfolios, what we need to know is the total
market value of all stocks in existence. We end up with the following
equation:
Investor
Allocation to Stocks (Average) = Market Value of All Stocks / (Market
Value of All Stocks + Total Liabilities of All Real Economic Borrowers)
We can get all of the information in this equation from the Flow of Funds report. T
he information is also conveniently available in FRED Graph. A link to the calculated metric is provided here, and to a separately downloadable version of each series, here.
Now, the Rest of the World creates an interesting complication.
Parts of our portfolios are composed of stocks, bonds and cash
denominated in foreign currencies (which do not show up in these series
and are not being counted, though they should be). But in the same way,
some parts of the portfolios of individuals in other countries are
composed of stocks, bonds and cash denominated in our currency (which
do show up in these series–and are being
wrongly
counted, given that our goal is to know our own allocations as domestic
investors). As an estimation, it works to assume that the two cancel
each other out.
The Unique Dynamics of Equity Asset Supply
The supply of cash and bonds that investors in an economy must hold
perpetually increases with the economy’s growth. The cash and bonds in
investor portfolios are literally “made from” the liabilities that real
economic borrowers take on to fund investment–the fuel of growth.
The following chart shows the annual growth of the total liabilities
of all real economic borrowers–which, again, is the total supply of cash
and bonds in investor portfolios–from 1952 to present. The growth rate
has ranged anywhere from around 5% per year to around 15% per year.
Right now, it’s at the low end of the spectrum.
Trivially, if the aggregate investor is going to maintain a constant
portfolio allocation to equities, the supply of equities must grow
commensurately
with the supply of cash and bonds. Recall that investors, in
aggregate, have to hold all of these assets at all times. It follows
mathematically that the ratios of the total supplies outstanding
must equal the ratios inside the “average” investor’s portfolio.
The supply of equities can increase in one of two ways: through the
issuance of new shares, or through price increases, i.e., increases in
the level of the stock market. The chart below shows the corporate
sector’s net issuance of new equity, as a percentage of total market
value, back to 1950.
As we see in the chart, the corporate sector is inherently averse to
the issuance of new equity. Each year, it adds very little additional
supply, on net. In various periods since the early 1980s, it’s actually
been a net destroyer of equity supply–taking supply
off the market through acquisitions and buybacks.
As we explained in our earlier piece on
earningless bull markets,
because the corporate sector does not issue sufficient amounts of new
equity each year to keep up with the continually increasing supply of
cash and bonds, stock prices
have to rise over the long-term.
If they don’t, stocks will become a smaller and smaller percentage of
the aggregate investor portfolio. Unless investors, on average, want
stocks to be a smaller component of their portfolios–because, for
example, they increasingly prefer to hold other assets–this outcome will
not be allowed. Stock prices will get pushed up on the growing
relative scarcity until the aggregate equity allocation preference is
satisfied.
Valuation: Challenging the Conventional Understanding
The total return of
an equity security depends on two factors: (1) the change in price from
purchase to sale, and (2) the dividends paid in the interim. Dividends
matter, but price is king. It drives total return.
Many investors don’t like the fact that price drives total return.
If price drives total return, it follows that total return is a
function of the shifting sentiment, preferences and expectations of
other
people–those who make up the market and “vote” on what the price will
be. Investors don’t want their returns to be subject to the arbitrary
“vote” of other people, and so they pretend that as stock market
speculators they are actually genuine businessmen who “buy” and “own”
companies to hold forever. They tell themselves that their returns will
somehow emerge directly from the cash flows of the underlying
businesses, regardless of what the market decides to do with price.
This point of view ignores the fact that it takes decades to recoup an equity investment via dividends, the
only
cash flows that are ever are actually paid out to buy-and-hold
investors. To claim a return on a stock in any other context, an
investor needs someone to sell it to. The price that other people are
wiling to pay is therefore important–
supremely important.
Rather than resist this fact puristically, our responsibility as
investors is to accept it and work within it, by understanding the
behavioral propensities of our fellow market participants, and getting
in front of emerging trends in how they choose to allocate their wealth.
Once we agree that price is king, the next question is: how is price determined in a market? Value mavens tend to think
that price is determined through the “rational” application of
normative valuation principles, such as “The stock market’s P/E ratio
should be 15, plus or minus a few points. If interest rates are low,
add a few points. If they are high, take a few points off.” On this
view, when the actual P/E ratio is above the appropriate value,
disciplined investors sell. When it’s below that value, they buy.
Through their buying and selling, the price moves to where it “should”
be, to “fair value”, given the earnings. Every so often, emotions
disrupt the process, but as with everything, they eventually pass, and
the process takes hold again. Value mavens look for these disruptions as an opportunity to capture excess return.
There’s certainly some truth to this view, but it doesn’t give the whole story. Ultimately, the price of equity is determined in the same way that the price of
everything
is determined–via the forces of supply and demand. For any given stock
(or for the space of stocks in aggregate), price is always and
everywhere produced by the coming together of those that don’t own the
stock and want to allocate their wealth
into it, and those that do own the stock and want to allocate their wealth
out of
it. If there is a different supply sought by the first group than
offered by the second, the price will shift until the imbalance
equalizes.
Now, there’s absolutely
nothing that says that this process
has to
equilibriate at any specific valuation. History confirms that it can
equilibriate at a wide range of different valuations. For perspective,
the average value of the P/E ratio for the U.S. stock market going back
to 1871 is
15.50. But the standard deviation of that average is a whopping
8.4, more than 50% of the mean. One standard deviation in each direction is worth
243% in total return, or
13% per year over 10 years.
The same is true of the popular Shiller CAPE. Its long-term average is
15.30–but with a standard deviation of
6.5, again almost 50% of the mean. Over the last 100 years, its value has stretched from as low as
5, to as high as
40–a difference of
700%
in total return. Note that the periods in which it took on depressed
values were hardly brief. It spent the entire decade of the 1940s at
bargain basement levels, frequently falling into single digits–this in
an environment where interest rates were pinned at zero.
Again, it’s all up to the allocators–they decide how much of their
wealth they are going to allocate into stocks, how much exposure they
are going to take on. Their preferences–or rather, their efforts to put
those preferences in place, by buying and selling–set the price.
Valuation is a byproduct of this process, not a rule that it has to
follow. In the 1940s, investors decided, for whatever reason–memories
of the Depression, a World War that the country might have lost, price
controls, high inflation–that they didn’t want large stock market
exposure. The fact that bond yields were meager did little to alter
this preference. And so valuations stayed extremely depressed. When a
vibrant, prosperous peacetime economy emerged in the 1950s, this
preference obviously changed, and the biggest bull market in history
ensued.
Buy-and-hold is painted as the informed, responsible, pro-American
thing to do with a portfolio. But, in terms of financial stability, it
can actually be a very destructive behavior.
Consider the classic buy-and-hold allocation recommendation: 60% to stocks, 40%
to bonds (or cash). What rule says that there has to be a sufficient
supply of equity, at a “fair” or “reasonable” valuation, for everyone to be able to allocate their portfolios in this ratio? There is no rule.
If everyone were to jump on the
buy-and-hold bandwagon, and decide to allocate 60/40, but equities were
not already 60% of total financial assets, then they would necessarily become
60% of total financial assets. The excess bidding would not stop until
they reached that level. It doesn’t matter that the associated price
increase would cause the P/E ratio to rise to an obscenely high value.
The supply-demand dynamic would force it to go there.
Now, in the real world, valuation
concerns can and do push back on the equity allocation process. But,
outside of extremes, they don’t tend to push back with very much force,
at least not on their own. Let me now explain some of the reasons why.
We can divide asset allocators into
two types: mechanical allocators, and active allocators. Mechanical
allocators are individuals that adhere to a strict allocation formula,
regardless of circumstance. Two examples would be buy-and-hold
investors that are always 100% invested (or always 60/40 invested,
periodically rebalancing, etc.), and 401K/retirement investors that
invest automatically in accordance with a pre-defined program. These
asset allocators follow their processes come rain or shine, therefore
they cannot be relied upon to push back against valuation excesses.
Though they are not the majority of the market, they are a significant
part of it–their presence makes a difference.
Active allocators, in contrast, dynamically alter their allocations
so as to maximize their returns. How do they try to maximize their
returns? By allocating their wealth into the assets whose returns they
consider to be the most attractive, adjusted for risk. It’s a
competitive process–they choose among their options, based on their
assessments of what those options are likely to produce.
Some might interpret this to mean that
they look at the earnings yields on stocks, the yields to maturity on
bonds, and the yield on cash, and then choose. Let’s suppose that asset
allocation were this easy–just find the asset class with the highest
yield, risk-adjusted, and allocate into it. We would still have to
answer the question: what is the future yield (at the current price) of
each asset class, adjusted for risk? To answer this question with
respect to cash is hard–we have to estimate future short-term interest
rates. With respect to bonds, even harder–we have to estimate credit
risk. With respect to stocks, the hardest of all–we have to estimate
forward earnings.
To estimate forward earnings for stocks, we have to answer difficult
questions about the future: What will the trajectory of nominal growth
be? How will profit margins evolve? Who can answer these questions with a
significant degree of empirical confidence, enough to be a contrarian
that consistently fights the market’s trends? Very few people, and
therefore the answers to the questions end up reducing to biased
reflections of prevailing mood, extrapolations of recent experience.
When the mood is high, and when recent experience has been positive,
investors embrace optimistic assessments of what the future
holds–therefore, equities look cheap, attractive. The market gets the
opposite of the valuation pushback that it needs. When the mood is low,
and when recent experience has been negative, investors embrace more
pessimistic assessments of what the future holds–therefore, equities
look expensive, unattractive. Again, the market gets the opposite of
the valuation pushback that it needs.
It turns out that even if fundamental questions about the future
yields of cash, bonds, and equities were resolved, asset allocation
still would not be as simple as choosing the security that offers the
highest yield (risk-adjusted). The goal, again, is to maximize
return. Return is not the same thing as yield.
Granted, if a security is held to maturity, or, in the case of
equities, for an infinite period of time, the return will mathematically
converge on the yield (provided, in the case of equities, that all
earnings are eventually distributed as dividends). But who among us
buys bonds to hold to maturity, or stocks to hold forever? Most
investor time horizons are not on the order of decades, centuries or
infinity, but on the order of days, months and years–a few days (the
time horizon of a swing trader), a few months (the expiration date on a
portfolio manager’s grace period with clients, at which point they will
start
leaving if things aren’t working), or a few years (long-term value investors playing with their own money).
To know the return of a security on a daily, monthly, or yearly time
horizon, it’s not enough to know what the yields are. You need to know
how the price is going to change. Given future cash flows (which we’ll
assume you’ve accurately estimated), this requires knowing what the
future valuation will be.
To illustrate, suppose that the P/E
multiple on stocks is 20, the 10 year bond yield is 2%, and the rate on
cash is 0%. Suppose further that the earnings of each of these
securities are going to remain constant. Can you say which security
will offer the highest return over the next few years? You might say
stocks–the earnings yield is 5%, a healthy 3% more than bonds. The
“premium” between the two is meaningfully higher than the historical
average. But that doesn’t tell you what the return of stocks will be.
If the investment mood sours ever so slightly over the next few years,
and the market concludes that a P/E of 17 is more “appropriate” than a
P/E of 20, the return will be negative–making stocks significantly less
attractive than the other available assets, despite the higher earnings
yield.
The only way that you can know what the future valuation of stocks
will be–so as to estimate future returns–is to apply some conception of
what’s fair, appropriate, reasonable, normal. But the range of what can
be rationalized as fair, appropriate, reasonable, normal is extremely
wide, too wide to be useful, and far too wide to provide reliable
pushback against a supply-driven market advance. Any number that is
chosen will likely be nothing more than a reflection of the prevailing
allocation preference–the prevailing appetite to be in or out of the
asset class, based on primordial “hunches” for where things are headed,
themselves just manifestations of recency bias. Once again, the market
will not get the valuation pushback that it needs.
Ultimately, valuation is a
learned
perception, learned through a process of social and environmental
reinforcement. The part of it that is not learned is just a crude
manifestation of the behavioral bias of anchoring–judging the
attractiveness of a price (or a ratio) by comparing it to the price (or
ratio) that one is “accustomed” to seeing. Ironically, it is anchoring,
not “valuation discipline”, that keeps the market from doing crazy,
bubbly things. People don’t like to pay higher prices tomorrow than
they could have paid today, or sell for lower prices today than they
could have sold for yesterday. That’s true regardless of what any
valuation metric says.
To illustrate, suppose that you spend a significant amount of time in
an environment where the average valuation is 25 times (or more). You
acclimatize to that valuation, it becomes your anchor, what you are used
to seeing. All of the “pundits” that you watch on TV tell you that
it’s normal. All of your friends, your fellow investors, say that it’s
normal. Most importantly, whenever you’ve bought at or below that
valuation, it’s
worked–the market has rewarded you with a positive outcome. And so you’re
comfortable buying at that valuation.
Obviously, in such an environment, you will come to perceive 25 times
earnings as a perfectly “appropriate” price for the market–a “fair”
multiple. If given an opportunity to buy the market at a lower
price–for example, 20 times–your reward circuitry will fire off,
creating an appetite to lock in the “bargain”, jump on the “big gains”
that it is offering.
But now switch the P/E in the example from 25 to 15. Suddenly, the
same P/E of 20 will make you feel like you’re overreaching, exposing
yourself to danger, buying too high. “Gee, what if the P/E falls back to
15, where it usually is, what I’m used to seeing–I’ll lose 25% in one
move! I can’t afford that.”
Because valuation is a learned
perception, driven by anchoring and by social and environmental
feedback, it tends to follow the market. As valuations rise in a bull
market, prior anchors wear off, and people get accustomed to higher
valuations–over time, the valuations stop feeling “high”–making room for
them to go even higher. Their perceived appropriateness gets
reinforced–socially, in the market discussion, and environmentally,
through the incredibly powerful feedback of actually making money. In a long, slogging bear market, the opposite occurs. Everything gets driven downwards.
To illustrate, consider the example of the most recent cycle. There
was a time, before the crisis, when we talked about trailing P/Es of 18
or 19 times earnings as reasonable–maybe even a bargain, relative to the
bubble that we had previously come out of. If we thought the trailing
P/E was too high in the summer of 2007, we were told to ignore
it–because the market was still very cheap on forward estimates
(themselves just a reflection of the optimism).
Then, we had the Great Recession, a massive, negatively-reinforcing series of economic events–
completely unrelated
to stock market valuation, mind you–that shattered everyone’s equity
world view. We suddenly found ourselves seriously debating whether 10
times trailing recessionary earnings was appropriate. We were
supposedly in a “new normal”, which, we feared, implied structurally
lower valuations.
The crisis eventually abated, and the economy entered a recovery.
But people still had to work off their fear conditioning and their
anchoring. As the market rose, the discussion shifted to whether 12
times was appropriate. Then, 14 times. Now, 17 times. The anchor, the
goalpost, has continued to move with the market. Pretty soon, the
discussion will come full circle again, and we will be asking ourselves
whether 18 or 19 times is appropriate. And, if the cycle isn’t cut
short by externalities, as it was the last time, we may one day find
ourselves discussing the appropriateness of 25 times–which
has been debated before in market history (a few years before the market proceeded to go to 40).
The drivers of this recurring pattern are obvious: not some innate
“sense” of “fair value”, but anchoring and the social-environmental
reinforcement of the market cycle itself. The perception of valuation
is not capable of creating persistent, reliable
resistance to the market cycle because it is an evolving
function of the
market cycle. At extremes, it can push back–but it can’t push back
when it falls within the very wide range of what can be rationalized,
which is where it usually falls, and where it is now.
Ultimately, we should be skeptical of claims that investors are innately hardwired to act in a certain way in response to any specific
concept, argument, or data point–whether it be “valuation”, or anything
else. Investors elicit behavioral responses to these types of
informational inputs, but the responses are not innate. They are
learned from the environment through a process of conditioning and
reinforcement.
Investors attend to concepts,
arguments, and data points, etc. as a means to an end–the end of
predicting what the return will be, which, in practice, means predicting
where the price is headed. If investors already have a hunch for where
the price is headed–which they often do–they will choose to embrace
whatever concepts, arguments, data points, etc. fit that hunch–or
they’ll just ignore the “mumbo jumbo” altogether, and go with their
“feel.” Similarly, if they are
just using the constructs to save face in social debate–to avoid having
to admit to themselves and to others that they are wrong–they will jump
on whatever concepts, arguments, data points, etc. show that they are
right (and ignore everything else).
When investors
don’t have a hunch for where prices are
headed, and are genuinely trying to use concepts, arguments, data
points, etc. to assess what to do, the ensuing assessment ends up being
something inherently
insecure, subject to constant feedback and molding from the market–responsive to the
result, and
ditched when no longer working.
You might confidently think, for example, that “good jobs number”
means “the recovery is picking up steam”, and that you should increase
your equity risk–but if the market starts consistently telling you that
this is wrong, by its actual
result, you will be affected by
the feedback. You may eventually find yourself pulled to function in
accordance with the opposite rule, that “good is bad.” “Maybe I
shouldn’t rush to increase my exposure here. Maybe these good jobs
numbers will lead the Fed to tighten–maybe that’s why the market is
selling off. Oops.”
Admittedly, when enough people grab onto and act on concepts,
arguments, data points, etc., they can become powerful forces that drive
market outcomes, especially when they have a basis in reality that
gives them credibility and forces people to believe them. The
reflexivity of price confirmation increases their allure and
persuasiveness, which causes more people to latch onto them, which fuels
further price changes, therefore more price confirmation, and so on in a
feedback loop that continues until reality pushes back.
However, it’s hard for valuation to pick up steam in this way,
because unlike other themes that might move markets, it has no objective
basis–it’s a personal opinion, easy to dismiss. It represents a
resistance to what the market itself is doing–and is therefore already
on the road to being disconfirmed simply by the fact that it is being
raised. If valuations are too high, then why are we where we at them?
Why aren’t we falling? Absent some kind of confirmation or feedback,
the theme can’t go anywhere.
Outside of cyclical downturns in which profits themselves plunge,
valuation never enters the discussion as a surprise, an “insult”, but
rather is only introduced gently, gradually, as the market
advances–usually by those who are
not part of the advance.
Market participants therefore have time to acclimatize to it as a
theme. It can’t produce the kind of shock and surprise that would catch
people offsides and provoke mounting, reflexively self-fulfilling
reactions. That’s why it usually takes a recession–or some kind of
noxious catalyst–to unwind a valuation excess. The excess alone can’t
correct itself.
In the tech bull market, the overvaluation theme had a hard time
pushing back even when index P/Es were in the 30s and 40s. People
talked about overvaluation, they worried about it. But then they kept
watching the price go up–so what do you do? You don’t tell the market
that it’s wrong, you trust your environment, you go with the flow. In
the end, it took a tight Fed, a recession with falling earnings, a slew
of corporate bankruptcies and scandals, unfamiliar accounting changes
that led to further earnings plunges, a terrorist attack, a war in the
Middle East, and so on, to finally get the market
moving reliably in the
downward direction, so that the valuation excess could be corrected.
Asset Supply: A New Framework for Thinking About Equity Returns
Value mavens will tell you that the market’s P/E ratio (either simple
trailing twelve months, or Shiller CAPE) is inversely correlated with
future returns over the long-term. A high P/E ratio implies low future
returns, a low P/E ratio implies high future returns.
But what makes this true? What is the force that brings about the
inverse correlation? Recall that we said that equity total return is a
function of price return and dividend return. We can aribtrarily
separate price return into the part that comes from Earnings Growth, and
the part that comes from the change in the P/E multiple. Leaving the
math
intentionally imprecise, we end up with the following equations:
(1) Total Return = Price Return + Dividend Return
(2) Price Return = Price Return from P/E
Multiple Change + Price Return from Earnings Growth (Realized if P/E
Multiple Were to Stay Constant)
Combining (1) and (2):
(3) Total Return = Price Return from P/E
Multiple Change + Price Return from Earnings Growth (Realized if P/E
Multiple Were to Stay Constant) + Dividend Return
Now, suppose that the market has a P/E ratio of 100. Why does it
have to produce a low or negative return? If corporate earnings are
growing at the rate of nGDP, say
6%, and the P/E ratio
stays at 100, then the return will be
6%–a perfectly healthy number.
Value mavens will respond that the P/E ratio cannot stay at 100. It
mean-reverts over the long-term. Its mean-reversion is the basis for
its inverse correlation with long-term future returns. If you buy at a
price below the normal P/E range, you will get the dividend return, plus
the return from earnings growth, plus the boost from multiple
expansion. Thus your return will be higher than normal.
Conversely, if
you buy above the normal range, you will get the dividend return, plus
the return from earnings growth–but those two gains will then be offset
by losses from multiple contraction. Thus your total return will be
lower than normal.
The problem with this construction, of course, is that it doesn’t model the
real
reasons that stock prices, in aggregate, change. Stock prices don’t
change because market participants choose to assign stocks different P/E
multiples. Rather, they change because the eagerness of the aggregate
investment community to allocate wealth into stocks rises or falls.
More investors try to “put money to work” than try to “take money off
the table”, and vice-versa. In the presence of the imbalance, the price
has no choice but to change.
As equity investors, we talk a lot
about asset allocation. It’s essentially the most important aspect of
portfolio management–how we’re allocated within the space of individual
stocks and bonds, and across the space of assets in general. I’m 85%
equity, 15% cash/bonds. You’re 50% equity, 50% cash/bonds. Joe over
there is 100% equity, 0% cash/bonds, etc.
What’s funny is that we never think to ask: how is it possible for
all of us to get to within a reasonable range of these preferred
allocations at the same time? After all, we’re trading a limited supply
of things amongst each other. The answer, of course, is that the
supply, properly understood, automatically shifts to meet our allocation
preferences via the changes in price that
we cause when we try
to put those preferences in place–that is, when we buy and sell at the
margin. In bull markets, we frequently find ourselves searching for
opportunities to put our allocation preferences in place–our equity
exposures are rarely as high as we would like them to be.
I therefore propose a new way of framing equity total returns. Take
the previous equation, and substitute “Aggregate Investor Allocation to
Stocks” and “Increase in Supply of Cash and Bonds” for “P/E Multiple
Change” and “EPS Growth.” We then have,
(1) Total Return = Price Return + Dividend Return
(2) Price Return = Price Return from
Change in Aggregate Investor Allocation to Stocks + Price Return from
Increase in Cash-Bond Supply (Realized if Aggregate Investor Allocation
to Stocks Were to Stay Constant) + Dividend Returns
Combining (1) and (2),
(3) Price Return = Price Return from
Change in Aggregate Investor Allocation to Stocks + Price Return from
Increase in Cash-Bond Supply (Realized if Aggregate Investor Allocation
to Stocks Were to Stay Constant) + Dividend Return
In the previous way of thinking, the earnings grow normally as the
economy grows. If the multiple stays the same, the price has to
rise–this price rise produces a return. When the multiple increases
alongside the process, the return is boosted. When it decreases, the
return is attenuated. The multiple is said to be mean-reverting, and
therefore when you buy at a low multiple, you tend to get higher returns
(because of the boost of subsequent multiple expansion), and when you
buy at a high multiple, you tend to get lower returns (because of the
drag of subsequent multiple contraction).
In this new way of thinking, the supply of cash and bonds grows
normally as the economy grows. If the preferred allocation to stocks
stays the same, the price has to rise (that is the only way for the
supply of stocks to keep up with the rising supply of cash and
bonds–recall that the corporate sector is not issuing sufficient new
shares of equity to help out). That price rise produces a return. When
the preferred allocation to equities increases alongside this process,
it boosts the return (price has to rise to keep the supply equal to the
rising portfolio demand). When the preferred allocation to equities
falls, it subtracts from the return (price has to fall to keep the
supply equal to the falling portfolio demand).
Now, instead of saying that the
P/E multiple is mean-reverting, we say that, for a given set of environmental contingencies–e.g., history, culture, demographics, etc.–the
equity allocation preference is
mean reverting. It rises in expansionary parts of the cycle, as people
become more optimistic about the future and more eager to maximize what
they see as attractive returns (“Kelly, we believe in this bull market,
we’re fully invested, our clients are fully invested.”–something you
hear frequently on CNBC these days), and it falls in contractionary
parts of the cycle, as people become less optimistic about the future
and more concerned about protecting themselves from losses (“Maria,
we’re cautious here, we’ve raised cash, we want to see signs of
stabilization before we deploy it.”–something that you heard frequently
on CNBC in ’08 and early ’09).
If you buy in periods where the investor allocation to equities is
low, you will get the dividend return plus the price return necessary to
keep the portfolio equity allocation constant in the presence of a
rising supply of cash and bonds, plus the price return that will occur
when equity allocation preferences return to more normal levels. You
will get in front of the equity supply squeeze of the next bull market,
when risk appetite and the associated desire to be invested in equities
recovers. Thus your return will be higher than normal. This is what
happened to investors in the 1980s.
If you buy in periods where the investor allocation to equities is
high, you will get the dividend return plus the price return necessary
to keep the portfolio equity allocation constant in the presence of a
rising supply of cash and bonds, but then you will have to subtract the
negative price return that will occur when equity allocation preferences
fall back to more normal levels. This is what happened to investors in
the 2001-2003 bear market.
This way of thinking about stock
market returns accounts for relevant supply-demand dynamics that pure
valuation models leave out. That may be one of the reasons why it
better correlates with actual historical outcomes than pure valuation
models.
It can explain, for example, the earningless bull market of the 1980s. Unbeknownst to many, earnings were not
rising in the 1980s bull market. They actually fell slightly over the
period–which is unusual. But prices didn’t care–they skyrocketed. The
P/E ratio ended up rising well above 20, despite interest rates near
10%–a valuation disparity never before seen in history. Valuation
purists can’t explain this move–they have to postulate that the “common
sense” rules of valuation were temporarily suspended in favor of
investor craziness.
But if we look at what investor allocations were back then, we will see that investors were already dramatically
underinvested in equities. If prices hadn’t risen, if investors had
instead respected the rules of “valuation” and refrained from jacking up
the P/E multiple, the extreme underallocation to equities would have
had to have grown even more extreme. It would have had to have fallen from a record low of 25% to an absurd 13%
(see blue line in the chart below, which shows how the allocation would
have evolved if the P/E multiple had not risen). Obviously, investors
were not about to cut their equity allocations in half in the middle of a
healthy, vibrant, inflation-free economic expansion–a period when
things were clearly on the up. And so the multiple exploded.
Now, recognize that this framework
leaves plenty of room to acknowledge the relevance of classical
valuation considerations. Disparities in valuation–between equities and
their own history (the valuation levels investors are anchored to,
accustomed to seeing, that they consider to be “normal”) and between
equities and other asset classes (bonds and cash)–can certainly
cause investors to want to change their allocations and exposures,
especially when the disparities are significant and can’t be dismissed
or rationalized away. If such a change unfolds, prices will rise or
fall accordingly. But if such a change doesn’t unfold, then prices are
not going to respond. Nor “should” they.
In a way, the metric already offers a rough estimation of classical
valuation. If the average investor allocation to equities is abnormally
low, then prices are probably abnormally low–the market’s probably
cheap. Likewise, if the average investor allocation to equities is
abnormally high, then prices are probably abnormally high–the market’s
probably expensive. And so an investor that is value-sensitive can
still use the metric as a way of assessing the market opportunity.
Comparing the Metrics on Performance
The following chart is a scatterplot
of the new metric. The y-axis is 10 year SPX total return, the x-axis
is the average investor equity allocation. The solid red line is the
current value of the metric. Note the excellent fit.
Right now, at its current value, the metric suggests a future 10 year nominal total return for equities of around
6%. Historically, whenever the market was at the current level, the low end of the return was a tad less than
5%, and the high end was around
9%.
The following charts show scatterplots of the other metrics. It’s
not even worth speculating on what returns they are suggesting right
now, because the fits are atrocious, especially in the current valuation
range. The Equity Q-ratio, for example, puts the market’s current
future 10 year returns anywhere from as low as
2% to as high as
9%. The Shiller CAPE puts the returns anywhere from as low as
0% to as high as
10%–with an ironic bias to the upside. Market Cap to GDP puts returns anywhere from
-3% to
2% (which is why it has become fashionable among bears).
In our earlier
piece,
we pointed out that the classic Shiller CAPE wrongly labeled the March
2003 market as significantly overvalued, and the March 2009 market as
barely below fair value (an epic, inexcusable blunder). We pointed out
that one advantage of the pro-forma CAPE, which tried to eliminate
accounting inconsistencies, was that it correctly identified the
market’s attractive valuation in these periods. It called March 2003 a
decent value, and March 2009 a screaming buy.
It turns out that like the pro-forma
CAPE, this metric also called 2003 and 2009 correctly. It signaled the
March 2003 market as a reasonable buy, and the March 2009 market as a
screaming buy, on par with levels seen at the secular low of the last
bear market, 1982.
A Note on “Overvaluation”
There’s a raging debate right now between bulls and bears over
whether the U.S. stock market is presently overvalued. The debate rages
on because the term is poorly defined. What, precisely, does it mean
to say that something is “overvalued”?
When we say that the stock market is
“overvalued”, we might mean that it’s currently valued more expensively
than it typically has been in the past. Over its history, the U.S.
stock market has offered, on average, some expected total return–say 8% to 10%. But now it’s priced for 5% or 6% (using our metric). So it’s “overvalued.”
Fair enough, bulls shouldn’t disagree. There are tons of reasons why the present stock market is unlikely to produce the 8% to 10% returns
that it has produced, on average, throughout history. On almost every
relevant measure, it’s starting out from a higher-than-average level.
The more important question, however, is this: why
should the stock market offer investors the average historical return
right now? If, over the next 10 years, bonds are offering investors 2.8%, and cash is offering them less than 1%, why should stocks be priced to offer them 8% to 10%?
How would that even be sustainable?
If equities were offering an 8% to 10% return, we would all choose to
allocate the bulk of our portfolios into them, rather than languish in
the ZIRPY nothingness of bonds and cash. There obviously isn’t enough
equity supply for all of us to allocate in that way, and so the price
would get pushed up, and the expected return pulled down–very quickly.
Now, it’s a mistake, obviously, to make an assessment of valuation
based strictly on a comparison between the yields of stocks and bonds,
as the Fed Model suggests we do. The yield of an equity security,
again, is
not the same
as its return. You can buy the market at 33 times earnings–a 3%
earnings yield–but your return over the next 10 years isn’t going to be
3%. It will probably be 0% (or less), as the market contracts from the
obscene valuation at which you bought it. If you were to try to justify
the stock market’s price by comparing its 3% yield to the 10 year bond
yield at 1%, touting the healthy risk premium (2%–greater than the
historical average), you would obviously be making a huge mistake. The
real risk premium on your stock investment would be negative–you would
end up with a loss.
But if you properly estimate long-term equity returns using other
methods–for example, the method I’ve proposed, which puts the future
return for the stock market at 5% to 6%–then it makes perfect sense to
assess the “appropriateness” of the current valuation through a process
of comparison with the investment alternatives. In the current case,
the alternatives of cash and bonds are offering much less than 5% to
6%–so there’s a decent risk premium in place for equities. T
he market is not
“overvalued”–it doesn’t “belong” at a lower valuation. To the
contrary, it’s priced where it should be, given the alternatives.
Investors have done their jobs properly, leaving no easy arbitrages to
exploit.
Now, if bears want to argue that it’s unwise to lock in 5% to 6%
equity returns right now (or even 3% or 4%), because the market cycle
will eventually produce selloffs in which greater returns are made
available, my response would be: who said anything about locking
anything in? Let’s time the market–as bears seem to want to do. I’m
all for that approach.
But timing the market doesn’t mean
boycotting it until it hands you, on a silver platter, the high returns that you’re demanding. After all, there’s an
excellent
chance that it won’t hand them to you–there’s no reason it has to.
General societal progress–particularly in the area of economic
policymaking–reduce the odds that it will. Rather, timing the market
means monitoring for the types of processes that tend to cause markets
to sell off–capturing equity returns
except when there are
signs of those processes emerging. “Valuation”–at least in the range
that we’re currently at–is not one of the processes that cause markets
to sell off (or, for that matter, that stop markets from selling off).
So stop worrying about it.
Big selloffs usually occur in association with recessions. That’s
where market timers make their money–by anticipating turns in the
business cycle. A hint to bears: if you’re calling for a recession
right now, in
this monetary environment, you’re doing it wrong.
