Tuesday, October 1, 2019

US Equities: Resilient Force or Case Study in Denial?

As readers of this blog know, I don't write much about whether stocks collectively are over or under priced, other than my usual start of the year posts about markets or in response to market crisis. There are two reasons. The first is that there is nothing new or insightful that I can bring to overall market analysis, and I generally find most market punditry, including my own, to be more a hindrance than a help, when it comes to investing. The second is that I am a terrible market timer, and having learned that lesson, try as best as I can to steer away from prognosticating about future market direction. That said, as markets test their highs, talk of market bubbles has moved back to the front pages, and I think it is time that we have this debate again, though I have a sense that we are revisiting old arguments.

Who are you going to believe?
One reason that investors are conflicted and confused about what is coming next is because there is are clearly political and economic storms that are on the horizon, and there seems to be no consensus on what those storms will mean for markets. The US equity market itself has been resilient, taking bad macroeconomic and political news in stride, and a bad day, week or month seems to be followed by a strong one, often leaving the market unchanged but investors wrung out. Investors themselves seem to be split down the middle, with the optimists winning out in one period and the pessimists in the next one. One measure of investor skittishness is stock price variability, most easily measured with the VIX, a forward-looking estimate of market volatility:

Here again, the market's message seems to be at odds with the stories that we read about investor uncertainty, with the VIX levels, at least on average, unchanged from prior years. If you follow the market and macroeconomic experts either in print or on the screen, they seem for the most part either terrified or befuddled, with many seeing darkness wherever they look. As in the Christmas Carol, the ghosts of market gurus from past crises have risen, convinced that their skill in calling the last correction provides special insight on this market. In the process, many of them are showing that their success in  market timing was more luck than skill, often revealing astonishing levels of ignorance about instruments and markets. (At the risk of upsetting those of you who believe these gurus, GE is not Enron and index funds are not responsible for creating market bubbles...)

Stock Market - Bubble or not a bubble? Point and Counter Point!
Why do so many people, some of whom have solid market pedigrees and even Nobel prizes, believe that markets are in a bubble? The two most common explanations, in my view, reflect a trust in mean reversion, i.e., that markets revert back to historic norms. The third one is a more subtle one about winners and losers in today's economy, and requires a more serious debate about how economies and markets are evolving. The final argument requires that you believe that powerful rate-setting central bankers and market co-conspirators have artificially propped up stock and bond prices. With each argument, though, there are solid counter arguments and in presenting both sides, I am not trying to dodge the question, but I am interested in looking at the facts.

Bubble argument 1: Markets have gone up too much, in too short a period, and a correction is due
The simplest argument for a correction is that US equity markets have been going up for so long and have gone up so much that it seems inevitable that a correction has to be near. It is true that the last decade has been a very good one for stocks, as the S&P 500 has more than tripled from its lows after the 2008 crisis. While there have been setbacks and a bad period or two in the midst, staying fully invested in stocks would have outperformed any market timing strategy over this period.

Is it true that over long time periods, stocks tend to reverse themselves? Yes, but when and by how much is not just debatable, but the answers could have a very large impact on anyone who decides to cash out prematurely. The easy push back on this strategy is that without considering what happens to earnings or dividends over the period, no matter what stock prices have done, you cannot make a judgment on markets being over or under priced.

Counter Argument 1: It is not just stock prices that have gone up...
If stock prices had jumped 230% over a period, as they did over the last decade, and nothing else had changed, it would be easy to make the case that stocks are over priced, but that is not the case. The same crisis that decimated stock prices in 2008 also demolished earnings and investor cash flows, and as prices have recovered, so have earnings and cash flows:

Notice that while stocks have climbed 230% in the ten-year period since January 1, 2009, earnings have risen 212% over the same period, and cash flows have almost kept track, rising 188%. Since September 2014, cash flows have risen faster than earnings or stock prices. It is possible that earnings and cash flows are due for a fall, and that this will bring stock prices down, but it requires far more ammunition to be credible.

Bubble Argument 2: Stocks are over priced, relative to history, and mean reversion works
The second argument that the market is in a bubble is more sophisticated and data-based, at least on the surface. In short, it accepts the argument that stocks should increase as earnings go up, and that looking at the multiple of earnings that stocks trade at is a better indicator of market timing. In the graph below, I graph the PE ratio for the S&P 500 going back to 1969, in conjunction with two alternative estimates, one of which divides the index level by the average earnings over the prior ten years (to normalize earnings across cycles) and the other of which divides the index level by the inflation-adjusted earnings over the prior ten years.
Download raw data on PE ratios
Note that on October 1, 2019, all three measures of the PE ratios for the S&P 500 are higher than they have been historically, if you compare them to the median levels, with the PE at the 75th percentile of values over the 50-year period, and normalized PE and CAPE above the 75th percentile. Proponents then complete the story using one of two follow up arguments. One is that mean reversion in markets is strong and that the values should converge towards the median, which if it occurs quickly, would translate into a significant drop in stock prices (35%-40% decline). The other is to correlate the l PE ratio (in any form) with stock returns in subsequent periods, and show that higher PE ratios are followed by weaker market returns in subsequent periods. 

Counter Argument 2: Stocks are richly priced, relative to history, but not relative to alternative investments today
If you are convinced by one of the arguments above that stocks are over priced and choose to sell, you face a question of where to invest that cash. After all, within the financial market, if you don't own stocks, you have to own bonds, and this is where the ground has shifted the most against those using the mean reversion argument with PE ratios. Specifically, if you consider bonds to be your alternative to stocks, the drop in treasury rates over the last decade has made the bond alternative less attractive. In the graph below, I compare earnings yields on US stocks to T.Bond rates, and include dividend and cash yields in my comparison:

Download raw data on yields and interest rates
In short, if your complaint is that earnings yields are low, relative to their historic norms, you are right, but they are high relative to treasury rates today. To those who would look to real estate, a reality check is that securitization of real estate has made its behavior much closer to financial markets than has been historically true, as can be seen when you graph capitalization rates (a measure of required return for real estate equity) against equity and bond rates. 

Bubble Argument 3: The market is up, but the gains have come from a few big companies
In a version of the glass half-empty argument, there are some who argue that while US stock market indices have been up strongly over the last decade, the gains have not been evenly spread. Specifically, a few companies, primarily in the technology space, have accounted for a big chunk of the gain in market capitalization over the period. There is some truth to this argument, as can be seen in the graph below, where I look at the FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) stocks and the S&P 500, in terms of total market capitalization:
As you can see, the last decade has seen a phenomenal surge in the market capitalizations of the FAANG stocks, with the $3.15 trillion increase in their market capitalizations alone explaining more than one-sixth of the increase in market capitalization of the S&P 500. In the eyes of pessimists, that gives rise to two concerns, one relating to the past and one to the future. Looking back, they argue that many investors have been largely left out of the market rally, especially if their portfolios did not include any of the FAANG stocks. Looking forward, they posit that any weakness in the FAANG stocks, which they argue is largely overdue, as they face pressure on legal and regulatory fronts, will translate into weakness in the market.

Counter Argument 3: The market reflects changes in how markets and economies work 
The concentration of market gains in the hands of a few companies, at least at first sight, is troublesome but it is not new. There have been very few bull markets, where companies have shared equally in the gains, and it is more common than not for market gains to be concentrated in a small percentage of companies. That said, the degree of concentration is perhaps greater in this last bull run (from 2009 to 2019), but that concentration represents forces that are reshaping economies and markets. Each of the companies in the FAANG has disrupted existing businesses and grabbed market share from long-standing players in these businesses, and the nature of their offerings has given them networking benefits, i.e., the capacity to use their rising market share to grow even faster, rather than slower. It is this trend that has drawn the attention of regulators and governments, and it is possible, maybe even likely, that we will see anti-trust laws rewritten to restrain these companies from growing more or even breaking them up. While that would be bad news for investors in these companies, those rules are also likely to enrich some of the competition and push up their earnings and value. In short, a pullback in the FAANG stocks, driven by regulatory restrictions, is likely to have unpredictable effects on overall stock prices.

Bubble Argument 4: Central banks, around the world, have conspired to keep interest rates low and push up the price of financial assets (artificially) 
As you can see in the earlier graph comparing earnings to price rates to treasury bond rates, interest rates on government bonds have dropped to historic lows in the last decade. That is true not just in the US, but across developed markets, with 10-year Euro, Swiss franc and Japanese Yen bond rates crossing the zero threshold to become negative.
If you buy into the proposition that central banks set these rates, it is easy to then continue down this road and argue that what we have seen in the last decade is a central banking conspiracy to keep rates low, partly to bring moribund economies back to life, but more to prop up stock and bond prices. The end game in this story is that central banks eventually will be forced to face reality, interest rates will rise to normal levels and stock prices will collapse. 

Counter Argument 4: Interest rates are low, but central bankers have had only a secondary role
Conspiracy theories are always difficult to confront, but at the heart of this one is the belief that central banks set interest rates, not just influence them at the margin. But is that true? To answer that question, I will fall back on a simple measure of what I call an intrinsic risk free rate, constructed by adding the inflation rate to the real growth rate, drawing on the belief that interest rates should reflect expected inflation (rising with inflation) and real interest rates (related directly to real growth).
Download raw data on interest rates, inflation and growth
Looking back over the last decade, it is low inflation and anemic economic growth that have been driving interest rates lower, not a central banking cabal. It is true that at the start of October 2019, the gap between the ten-year treasury bond rate and the intrinsic risk free rate is higher than it has been in a long time, suggesting that either Jerome Powell is a more powerful central banker than his predecessors or, more likely, that the bond market is building in expectations of lower inflation and growth.

Implied Equity Risk Premiums: A Composite Indicator
Did you think I would have an entire post on stock markets, without taking a dive into implied equity risk premiums? Unlike PE ratios that focus just on stock prices or treasury bond rates that focus just on the alternative to stocks, the implied equity risk premium is a composite number that is a function of how stocks are priced, given cash flows and expected growth in earnings, as well as treasury bond rates. In my monthly updates for the S&P 500, I compute and report this number and as of October 1, 2019, here is what it looked like:
Download spreadsheet

The equity risk premium for the S&P 500 on October 1, 2019, was 5.55%, and by itself, you may not know what to do with this number, but the graph below shows how this number has changed between 2009 and 2019:
Download historical ERP
There are two uses for this number. First, it becomes the price of equity risk in my company valuations, allowing me to maintain market neutrality when valuing WeWork, Tesla or Kraft-Heinz. In fact, the valuations that I will do in October 2019 will use an equity risk premium of 5.55% (the implied premium on October 1, 2019, for the S&P 500) as my mature market premium. Second, though I have confessed to being a terrible market timer, the implied ERP has become my divining rod for overall market pricing. An unduly low number, like the 2% that I computed at the end of 1999 for the S&P 500, would represent market over-pricing and a really high number, such as the 6.5% that you saw at the start of 2009, would be a sign of market under-pricing. At 5.55%, I am at the high end of the range, not the low end, and that backs up the case that given treasury rates, earnings and cash flows today, stock prices are not unduly high.

My Market View (or non-view)
I am neither bullish nor bearish, just market-neutral. In other words, my investment philosophy is built on valuing individual companies, not taking a view on the market, and I will take the market as a given in my valuation.  Does this mean that I am sanguine about the future prospects of equities? Not in the least! With equities, it is worth remembering that the coast is never clear, and that the reason we get the equity risk premiums that I estimated in the last section is because the future can deliver unpleasant surprises. I can see at least two ways in which a large market correction an unfold.

An Implosion in Fundamentals
Note that my comfort with equities stems from the equity risk premium being 5.55%, but that number is built on solid cash flows, a very low but still positive growth in earnings and low interest rates. While the number is robust enough to withstand a shock to one of these inputs, a combination that puts all three inputs at risk would cause the implied ERP to collapse and stock pricing red flags to show up. In this scenario, you would need all of the following to fall into place:
  1. Slow or negative global economic growth: The global economic slowdown picks up speed, spreads to the US and become a full-fledged recession.
  2. Cash flow pullback: This recession in conjunction causes earnings at companies to drop and companies to drastically reduce stock buybacks, as their confidence about the future is shaken.
  3. T. Bond rates start to move back up towards normal levels: Higher inflation and less credible central banks cause rates to move back up from historic lows to more "normal" levels.
I can make an argument for one, perhaps even two of these developments, occurring together, but a scenario where all three things happen is implausible. In short, if economic growth collapses, I see it as unlikely that interest rates will rise.

A Global Crisis with systemic after shocks
There is no denying that there are multiple potential crises unfolding around the world, and one of these crises may be large enough, in terms of global and cross sector consequences, to cause a major market pull back. It is unclear what exactly equity markets are pricing in right now, but the triggering mechanism for the meltdown will be an "unexpected" crisis development, leading equity risk premiums to jump to higher levels, as investors reassess market-wide risk. For the crisis to have sustained consequences, it has to then feed into economic growth, perhaps through a drop in consumer and business confidence, and also into earnings and cash flows. After a decade of false alarms, investors are jaded, but the crisis calendar is full for the next two months, as Brexit, impeachment, Middle East turmoil and the trade war will all play out, almost on a daily basis.

Bottom Line
I am not a macroeconomic forecaster, and I am going to pass on market timing, accept the fact that the markets of today are globally interconnected and more volatile than the markets of the last century, and stick to picking stocks. I hope that my choice of companies will provide at least partial protection in a market correction, but I know that if the market is down strongly, my stocks will be, as well. I know that some of you will disagree strongly with my market views, and I will not try to talk you out of them, since it is your money that you are investing, not mine, and your skills at market/macro forecasting may be much stronger than mine. If you are a master macroeconomic forecaster who believes that a perfect storm is coming where there is a global recession with a drop in earnings and a loss or corporate confidence (leading to a pull back on buybacks), perhaps accompanied by high inflation and high interest rates, you definitely should cash out, though I cannot think of a place for that cash to go, right now.

YouTube Video

Linked Datasets
  1. PE ratios for the S&P 500
  2. Stock Yields and Interest Rates: US
  3. Intrinsic Riskfree versus 10-year T.Bond Rate 
  4. Historical Implied Equity Risk Premiums: US


Antonio Marques Mendes said...

It is really impossible to call the market peak. I have been cash biased for the last four years, while waiting for a bear market. My investors are getting impatient, and I am willing to accept my mistake and invest all that cash again. There are two reasons for that: bull markets after a major crash seem to last longer (it happened after 1934, and it seems to be happening again after 2009). Central banks are addicted to low rates and might go on for a long time.

Yet, I am a terrible market timer. So, I am afraid that stocks will crash again just after I have become fully invested again...

Anonymous said...

What’s wrong with staying in cash during periods when market PE ratio significantly exceeds its historical median?

Steve Kamman said...

This piece was fantastic, well written, and perfectly timed. I agree with the thrust of your conclusions and have been wrestling with some of the same questions myself, but you pulled it together much better than I had managed to so far. Cheers.