Monday, January 4, 2016

January 2016 Data Update 1: The US Equity Markets

Like most of you, I start every new year with optimism and hopeful resolutions, but the first week each year for the last two decades has been what I term my “Moneyball” week. During the week, I download the raw data on every publicly traded company that is listed globally, and work at converting that data into the industry averages that you see on my website. I do the analyses to keep myself grounded, since it is so easy to form preconceptions about market and corporate behavior that have no basis in reality. As I update the data, I will be doing a series of posts on how the numbers have or have not changed during the course of the last year. In this, the first of the series, I will start by looking at US equity markets, as we start the new year.

Looking Back
It was not a good year for US equity markets, but given circumstances, it could have been a lot worse. The S&P 500 was almost unchanged during the course of the year, though indices of some subsets of the market did worse:
Source: Standard and Poor's
During 2015, large cap stocks did better than small cap stocks, growth outperformed value and momentum investing provided a positive payoff. 

If there is a word that I would use to describe US equity markets in 2015, it is “resilient”, since they had to weather two significant crises. During the summer, China, the engine for global economic growth for much of the last decade, had a market meltdown, triggered by an economic slowdown. (Take a look at the post that I did at the height of the crisis in late August). The commodity markets, which collapsed in 2014, continued their decline in 2015, albeit at a slower pace. Notwithstanding these developments, the S&P 500 ended 2015, with a return of 1.36%, if you count in dividends, higher than the returns you would have generated on T.Bills (0.21%) or T.Bonds (1.28%) for the year. Incorporating the returns from 2015 into the historical data, the compounded annual returns on stocks, T.Bonds and T.Bills are shown below for periods going back as far as 1928:

Source: Damodaran Online
The historical premium earned by stocks, relative to treasury bonds, inched down to 4.54% for the 1928-2015 time period, from 4.60% for the 1928-2014 time period. 

Looking forward
The equity risk premium is the extra return that investors demand for investing in stocks as opposed to putting their money in a riskless asset, and it is the composite statistic that best captures how stocks are priced in the aggregate. It is also a number that I have posted on extensively, that I update at the start of every month on my website, and write an extended update about, each year. My preferred approach for estimating the premium is to start with current stock prices, estimate expected cash flows from owning stocks and to solve for the discount rate (expected return or internal rate of return). At the start of 2016, using the S&P 500 as the market index, the collective cash flow from dividends and buybacks as the cash flow from stocks and a top down estimate of growth in earnings for the index as the growth rate in the cash flows, I obtain an equity risk premium (ERP) of 6.12%:
This equity risk premium serves two purposes. First, it is a key input in valuing individual companies, becoming a part of the costs of equity and capital of all companies; a higher ERP translates into higher discount rates and lower values. Second, by comparing the current ERP to what you believe a fair ERP should be (perhaps by looking at historical averages), you can make a judgment on whether you think the market is under or over valued. If the current premium is higher (lower) than what you think is fair, stocks are under (over) valued. 
Source: Damodaran Online
On that comparison, the high ERP on US stocks (or at least those in the S&P 500) is reason for optimism. 

Cautionary Notes
The optimism emanating from the high current ERP should be tempered, though, since the drivers of that premium are much softer than they were a year ago, when the ERP was 5.78%. Largely as a consequence of the commodity price decline, base year earnings for the S&P 500 companies dropped almost 10% in 2015. In fact, the ERP at the start of 2016 is being elevated by two forces, the first is that the T.Bond rate continues to be low (by historic standards) and the second is that cash returned  (about 60% in buybacks) by US companies rose last year by 4% during the year. The net result of the declining earnings and increasing buybacks is that the cash returned last year was 101.54% of earnings, unsustainable over time

To correct for this, I reestimated the ERP, adjusting the cash return down to a more sustainable number over the long term. In effect, I lower the cash return ratio each year over the next five years to reach about 84% of earnings in year 5:

The resulting ERP is 5.16%, still higher than the 75th percentile (4.93%) for the 1960-2015 period, but the margin for error is much smaller than it was last year. If the continued drop in commodity prices in the last quarter of 2015 affects earnings for the index in 2016 and/or T.Bond rates rise sharply, the ERP will decline. This year, I plan to monitor (and report) this buyback-adjusted ERP , in addition to my unadjusted estimates, more closely than in prior years.

Bottom Line
I am more wary about equities going into 2016 than I was entering 2015, but my feelings about the market have never been a reliable predictor of what stocks actually do during the year. Thus, I will do what I always do at the start of every year, invest on the presumption that I am not  market timer and that I am better off investing in individual companies that I think are under valued. My faith in intrinsic value will be tested by price movements in the wrong direction and I hope that I will not be found wanting.



Anonymous said...

Thanks Prof. the post cannot be more interesting, especially in these days of market turbulence. Just a quick observation the high growth rate for the next 5 years of 5.5% which come from analysts, how about change it to 2.8%, 2.7% which is the US and world GDP growth rate estimated by fed and world bank. Here I am assuming that the corporate earning in U.S. Won't grow very far from the world and U.S. GDP rate. And if you change this number I think the ERP will drop by another 1%. Thank you again for your great blog and post.

Happy New Year.

Raffaele De Gennaro said...

Dear Professor,
what I like most of you is the desire to be continually in search of the truth, letting your mind to be wide open and never feeling satisfied by your findings, even if based on an enviable, very long career.
This, together with your seraphic conclusion (that is to be an investor with a life jacket), are the best lessons we should understand.

Thank you very much for being a so inspiring guide,
Raffaele De Gennaro

Anonymous said...

Hi Prof Damodaran,

I will be following this series with great interest. I'm always checking the blog everyday for new entries. I am currently studying to further my qualifications in my profession but once that is over I hope to learn from your online valuatioon classes.

I am just wondering how do you personally narrow down a list of prospective companies that you wish to value?

Other investors usually use screens with traditional value metrics to obtain a list of candidates to investigate. These traditional value screens would miss out on companies such as Twitter. Do you use a screen yourself?

If I may, what are your thoughts on passive investing. If one was to accept that they do not have the knowledge or inclination to actively invest, do you agree with the common wisdom that dollar cost averaging into an index ETF would yield adequate results over the long-term (till restirement)?

Thank you in advnace.

Unknown said...
This comment has been removed by the author.
Anonymous said...

How can you be confident that the unadjusted ERP does not already reflect the unsustainable levels of buybacks from 2015?

Aswath Damodaran said...

I am not sure what you mean when you say that the unadjusted ERP does not already reflect the unsustainable buybacks. The unadjusted ERP is a computed number, not a market number. The level of the index is the market number. If you are saying that the market may be unrealistically expecting buybacks to stay at 101.54% of the earnings and grow at the same rate as the earnings, you may be right, but it is mathematically impossible in perpetuity.

Anonymous said...

My apologies on the vagueness. I was asking whether or not it would be possible that the market also believes the level of buybacks was at an unsustainable level in 2015, and this concern would be expressed in a higher unadjusted ERP relative to history. I think my answer would be the explanation you gave on computed vs market numbers.

Unknown said...

Hi Professor.

Thank you for your post. One question - what S&P Value Index are you using - this is not the S&P 500 Value Index but another? The S&P Growth Index return matches the S&P 500 Growth INdex of 3.75% whereas the S&P 500 Value Index had a price return of -5.59% vs the number quoted in the post of -10.23%. What S&P Value Index does the post reference?

Thank you.

Unknown said...

Hi Professor

My apologies I now see it you are referencing the S&P Composite 1500 Pure Value Index.

Makes sense now.


Unknown said...

Thanks a lot Sir helped me clear a lot of doubts, wish had a teacher like u in most of my subjects would have been a fun and most importantly an ENJOYABLE learning experience.

Anonymous said...

Dear Professor,

first of all the important stuff, a big thank's.

I came across your online valuation classes, all of your material and this blog a couple of months ago and thanks for all that and your effort in distributing your knowledge. Actually you got me fascinated and I am one of those guys downloading your lectures as a podcast and listening closely in the car, that's why I have a couple of questions to your post:

1. What type of datasource would you use for international stocks (e.g. from Europe or more specifically Germany) to come up with dividends and buy backs? Do you have any advice on that?

2. While in international markets market cap and trading volume is often driven from just a couple of stocks, what would you recommend to do in these markets to arrive at an implied premium? For instance, in Germany approx. 50-60% of the overall German market cap stems from the 30 DAX stocks. Is it enough to keep track of this narrow set, which might be quite easy given data constraints on other stocks or does a prudent investor needs to go a bit further than that?

3. I see your point in the high payout ratios, but I do not grasp why the low interest rates inflate the implied premium to "abnormal levels". Of course the low rates are subtracted, but so are high rates as well. In one of your classes you advice students to refrain from adjusting interest rates to "more realistic or more normal" levels. Why do you argue differently in that case?

So thank's again, and good luck for your fundamental investment style,


Aswath Damodaran said...

1. I use S&P Capital IQ as my primary raw data source for non-US companies and it does report buybacks for companies.
2. Liquidity is a an issue, but the numbers that I track are more fundamentals (earnings, revenues etc.) than market-driver.
3. The implied premium is the difference between the expected return on stocks and the risk free rate. If the latter is abnormally low, the implied premium has to high.

Anonymous said...

Hi Professor,

Thanks for your insightful post. I do not understand how you calculated the sustainable payout ratio in the adjusted ERP chart. It shows as [1 - (stable growth rate / ROE)]. Can you please explain why that's the case?

GM said...


Instead of cash returned as a percentage of earnings, would be more appropriate to consider cash returned as a percentage of free cash flow?