As an exceptionally good year for stocks comes to an end, the talk of stock market bubbles fills the air. Among others, Robert Shiller warns us, that based upon his market measure of value, that we are in "bubble" territory and almost every acquaintance that I have starts off by asking me whether I think that US equities are ready to pop. I have great respect for Shiller, but I also know that the market is bigger than any of us, Nobel prize winners or not. As the the new year begins, and we all turn our attention to the state of our portfolios, I am sure that this discussion will only get louder. You may be accuse me of being "chicken" but I am loath to get into this guessing game, since market timing is not my strength. However, the scattered nature of the debate, where each side (bubble or no bubble) finds something in the market that supports its thesis reminds me of the story about the blind men who are allowed to touch an elephant and come to very different conclusions about what it looks like. Perhaps, the only contribution I can make to this discussion is to provide a framework that can be used to make sense of the different perspectives on the future of stocks and at lease provide some perspective on how investors can look at the same numbers and come to such different conclusions.
Standard Pricing Metrics: In the eye of the beholder?
Most of the arguments about whether we are in bubble territory still are built around the standard metrics, where equity multiples are compared across time and markets. In fact, a surprisingly large number of arguments, pro and con, are based on the PE ratio, with variants on earnings used by each side to make its case. Those who remain optimistic about the market focus on trailing or forward earnings and note that the trailing and forward PEs, while high can be explained by low interest rates. Those who are pessimistic about markets either make their comparisons to the historic averages for the PE ratio for the market or argue that earnings for the market are high today (in both absolute levels and stated as a percent of revenues) and are ripe for adjustment. Thus, it is no surprise that those who use cyclically-adjusted PE (CAPE) are sounding alarm bells about the market.
Valuing the market
Like any other investment, the value of a market is determined by cash flows, growth (level and quality) and risk in stocks. Consider an investor who buys the equity index. That investor can lay to claim to all cash paid out by the companies in the index, composed of both dividends and stock buybacks. If we forecast out these composite cash flows, the value of the index in intrinsic terms can be stated as a function of the following variables:
Holding all else constant, higher base-year cash flows and higher growth rates lead to higher values for equities, whereas higher risk free rates and equity risk premiums result in lower values for equities.
The status quo
Given these drivers of equities, where do we stand right now? The S&P 500 starts the year (2014) at 1848.36, up almost 30% from it's level of 1426.19, a year prior. While that jump in stock prices makes most investors wary, it is also worth noting that the cash paid out to equity investors in the twelve months leading into the start of 2014 amounted to 84.16, up 21.16% from the cash flows to equity in the twelve months leading into the start of 2013. As the economy strengthened over 2013, the US treasury bond rate also climbed from 1.76% at the start of 2013 to 3.04% at the close of trading on December 31, 2013. To estimate the cash flows in future years, we used the estimates of earnings from analysts who track the aggregate earnings on the S&P 500 (top down estimates), resulting in an earnings growth rate of 4.28% a year for the next five years, which we also assume to be the growth rate in the cash flows paid out to equity investors (thus keeping the payout stable at 84.13% of earnings). As a final input, we set the growth rate in cash flows beyond year 5 at 3.04%, set equal to the risk free rate.
The simplest way to bring these numbers together is to look for a discount rate that will make the present value of the cash flows (i.e., the intrinsic value of the index) equal to the traded value of 1848.36. That discount rate works out to be 8.00% and can be viewed as the expected return on equities, given my estimates of cash flows. Netting out the risk free rate from that number yields an implied equity risk premium of 4.96%.
Are we in a bubble?
One way to evaluate whether stocks are collectively misplaced is to compare the implied equity risk premium today to what you believe is a reasonable value. That "reasonable value" is clearly up for discussion but to provide some perspective, I have reproduced the implied equity risk premiums for the S&P 500 from 1961 to 2013 in the figure below.
The equity risk premium of 4.96% is clearly down from its crisis peaks (6% or higher), but it is still higher than the average of 4.04% from 1961-2013 and slightly above the average of 4.90%, from 2004-2013. Market optimists would point out that unlike the market peak in early 2000, when the implied equity risk premium of 2.00% was well below the historic norms, the equity risk premium today is at acceptable or even above acceptable levels. Market pessimists, though, will note the equity risk premium in September 2008 was also just above the historic norms and that it provided little protection against the ensuing crash.
Stress Testing the Market
The assessment of the equity risk premium above is a function of the risk free rate and my estimates of expected cash flows and growth. Since all of these can and will change over 2014, it is prudent to evaluate which of these variables pose the greatest threat to equity investors.
1. Risk free rate
While the US T.Bond rate has rebounded from its historic lows, it remains well below its norm, as indicated in the figure below:
I remain a skeptic and believe that low economic growth was a much bigger contributor. In fact, as economic growth rebounded in 2013, interest rates rose, and if expectations of continued growth in 2014 come to fruition, I believe that rates will continue to risk, no matter what the Fed decides to do. While that rise in rates may seem like an unmitigated negative for stocks, the net effect on stocks will be a function of whether the economic growth also translates into higher earnings/cash flow growth. It is only if interest rates rise at a much steeper rate than earnings growth rates increases that stocks will be hurt.
2. Equity Risk Premium
While the equity risk premium today is not low, relative to historic standards, the last five years have taught us that market crises can render historic norms useless. Thus, there is always the possibility that 2014 could bring a macro crisis that could cause equity risk premiums to revert back to 2009-levels. In the following table, I estimate the intrinsic value for the S&P 500 at different equity risk premiums.
3. Cash flows
It is clear that US companies returned to their pre-crisis buyback behavior in 2013 and there are some who wonder whether these cash flows are sustainable. To answer that question, we looked at dividends and buybacks from 2001 to 2013 in the figure below, and compare them to the earnings on the index each year.
Are US companies returning too much cash to investors? It is true that the 84.13% of earnings paid out in dividends and buybacks in 2013 was higher than the average of 79.96% from 2004-2013, but the difference is not large. The bigger danger to cash flows to equity is a collapse in earnings. In fact, using the CAPE rule book, we estimated the inflation-adjusted earnings on the index each year from 2004 to 2013 and computed a ten-year average of these earnings of 82.64. Applying the average payout ratio of 79.96% to these earnings results in a much lower cash flow to equity of 66.08. Using those cash flows, with an equity risk premium of 4.90%, results in an intrinsic value for the index of 1467.89, about 20.6% lower than the index level on January 1, 2014. Thus, it is no surprise that those analysts who use PE ratios based on average earnings over time come to the conclusion that stocks are over priced.
4. Growth Rates
The use of analyst estimates of growth can make some of you uneasy, since analysts can sometimes get caught up in the mood of the moment and share in the "irrational exuberance" of the market. While using top down estimates (as opposed to the estimates of growth in earnings for individual companies), provides some insulation, there is a secondary test that we can use to judge the sustainability of the predicted growth rate. In particular, when the return on equity is stable, the expected growth in earnings is a product of the retention ratio (1- payout ratio) and the return on equity:
Using the 84.13% payout ratio and the return on equity of 15.790% generated by the market in 2013, we estimate an expected growth rate in earnings of 2.67%, lower than the analyst estimate of 4.28%. Substituting in this growth rate lowers the value of the index to 1741, making it over valued by about 6%, at its current level.
Try it yourself
I know that you will probably have your own combination of fears and hopes. To help convert those into an intrinsic value for the index, I have the spreadsheet that I used in my analysis for download. When you open the spreadsheet, you will be given a chance to set your combination of the risk free rate, equity risk premium, cash flows and growth and see the effect on value. The spreadsheet also has historical data on risk free rates and equity risk premiums embedded as worksheets.
As I look at the fundamentals and the possibilities for 2014, I am wary but no more so than in most other years. There are always scenarios where the intrinsic value of the index will drop and the biggest dangers, as I see them, come from either a global crisis that blindsides markets or from a precipitous drop in expected earnings. Can I guarantee that these scenarios will not unfold? Of course not, and that is precisely why I would require an equity risk premium for investing in stocks and will continue to diversify across asset classes and markets. You may very well come to a different conclusion, and whatever it is, I wish you only success in the coming year, even if it comes at my expense. Happy New Year!
End of the year (2014) data update posts