SERIOUS MONEY:JOHN BURR Williams wrote in his 1938 classic The Theory of Investment Valuethat "investment analysis measures the relative rather than the absolute value of any stock, and leaves to the economist the broad question of whether stocks are selling too high or too low", writes CHARLIE FELL
More than seven decades later, relative valuation continues to be the most popular technique employed by investment professionals.
One of the more dubious methods used to assess the relative allure of the stock market is to compare the major market average’s dividend or earnings yield with the current level of long-term interest rates. The so-called Fed model received almost universal approval as the Holy Grail of valuation following Alan Greenspan’s Humphrey-Hawkins testimony to Congress on July 22nd, 1997.
The report that accompanied Greenspan’s testimony showed a strong positive correlation between the 10-year Treasury yield and the S&P 500’s earnings yield; it said changes in the price/earnings multiple – the inverse of the earnings yield – “have often been inversely related to changes in long-term Treasury yields”.
The Federal Reserve’s presumed approval of the valuation tool emboldened the bullish strategists on Wall Street. Earnings yield replaced the dividend yield as a key input and opinion replaced fact as forecast earnings were favoured over historic profit numbers.
The use of overly-optimistic numbers may be damning enough, but the harshest criticism of the Fed model is that it is theoretically invalid and simply does not work in practice. Indeed, the price investors are willing to pay for a dollar of earnings is in secular decline even though the yield on 10-year Treasuries has dropped to just 2½ per cent. The earnings yield based on one-year forecast numbers is six percentage points above the 2½ per cent equilibrium value implied by the Fed model, and long-term interest rates are only barely higher than the forecast dividend yield.
The widely-accepted positive correlation between the dividend yield and long-term interest rates has crumbled and turned negative. Indeed, the coefficient of correlation since the end of 1999 has been an impressive -0.8 with statistical significance.
What explains the spectacular breakdown in the Fed model? The most obvious answer is that it was theoretically flawed from the outset. Secular shifts in long-term Treasury yields are typically caused by sizable movements in inflation expectations, but inflation per se should have no impact on the valuation of stocks since they are a claim on real cash flows. However, the risk premium that investors require for equity investment increases as the economy moves away from price stability towards either an inflationary or deflationary regime.
The verdict of history suggests that investors are willing to pay most for a dollar of earnings when the inflation rate is contained between 2 and 4 per cent. Outside this range, valuation multiples fall and yield measures rise. Thus, stock yields based on either dividends or earnings tend to be positively correlated with bond yields when inflation expectation move towards or away from an inflationary regime, and exhibit a negative correlation when inflation expectations move towards or away from a deflationary regime.
Why do inflation expectations matter? Prices provide consumers and producers with the information they need to assess the relative value of goods and services. However, the information content in prices declines significantly when the aggregate price level changes unpredictably and during deflationary and inflationary regimes it becomes difficult to distinguish between relative prices that are advantageous. The historical evidence shows that both deflationary and inflationary regimes lead to greater economic volatility and, consequently, individuals require additional compensation for investment in stocks or higher dividend yields and lower price/earning multiples.
The stock market’s dividend yield was routinely above long-term interest rates throughout the 19th century and through the first half of the 20th century, so the current narrow gap can hardly be described as an outlier. The apparent anomaly persisted due to high levels of economic volatility, and a business climate that, apart from occasional war-induced inflations, was notable for its periodic bouts of deflation.
Stocks prospered through the mid-1960s, but struggled in the late-1960s and early-1970s as accommodative monetary policy, expansive fiscal policy and a collapse in the Bretton Woods system of fixed exchange rates all contributed to runaway inflation. The positive correlation between stock and bond returns became conventional wisdom.
The positive correlation continued during the 1980s and 1990s as the “Great Inflation” gave way to disinflation and a return to price stability. Both stocks and bonds enjoyed impressive bull markets, but they parted company more than a decade ago as deflation concerns came to the fore.
The US economy is just one recession away from deflation and, consequently, the flawed Fed model will continue to fail.
www.charliefell.com
