SERIOUS MONEY:IT IS SAID that patience is a virtue, and the proverb would certainly appear true of the world's financial markets, where the persistent rise in stock prices through the summer months has proved particularly frustrating to investors of a value persuasion.
The upward march in market averages worldwide has pushed reliable valuation indicators into nosebleed territory, virtually assuring subpar returns in the years ahead.
The cyclically-adjusted price-earnings multiple, or Cape, has become a popular valuation metric since the publication of Robert Shiller’s Irrational Exuberance at the height of the technology bubble more than a decade ago.
The Yale professor demonstrated that the Cape – calculated by dividing the current index value by 10-year average earnings – is a reliable predictor of long-term real returns for the US stock market.
Simply put, high values of 20 or more for the ratio have been followed by disappointing real returns over long horizons, while low values of 10 or less have consistently contributed to superior returns over extended periods.
For example, the Cape reached unprecedented levels of more than 45 at the end of 1999, and not surprisingly, the stock market delivered negative annualised real returns of 3.5 per cent over the subsequent decade.
Conversely, the stock market traded on a Cape of less than 10 at the end of 1948, and delivered annualised real returns of more than 18 per cent over the following decade.
Fast forward to today, and the more than doubling in stock prices since the major stock market averages bottomed during the spring of 2009, has lifted the US Cape well above thresholds that have historically spelt trouble for equity investors.
The current reading, at more than 22, is close to levels that marked the beginning of prolonged periods of stock price stagnation at the beginning of the 20th century, and once again during the mid-1960s.
Several investment practitioners argue today’s reading should not be taken at face value for a variety of reasons.
First, although the use of 10-year average earnings in the denominator usually smoothes for the ups and downs in the business cycle, the sheer magnitude of the collapse in corporate profitability during the Great Recession means that the current reading for 10-average earnings seriously understates the listed corporate sector’s cycle-adjusted earnings power.
Second, it is contended that the historically-unprecedented low level of long-term interest rates today, means investors should attach a higher multiple to cyclically-adjusted earnings. The two factors combined means that bullish commentators view equity values as more than appropriate at current levels.
Unfortunately, the argument rests on thin ice.
First, it is beyond dispute that the collapse in corporate profitability during the steepest downturn since the 1930s, pushed current earnings well below their 10-year average, but the quick recovery that followed means the number of quarters spent below average was rather brief, while the powerful climb to record levels means that current 10-year average profits are not far removed from the values suggested by more sophisticated measures.
Indeed, the use of a Cape that employs median 10-year earnings reaches the same conclusion as the Shiller measure – stocks are overvalued.
The second argument rests on the case that lower long-term interest rates should equate to higher equity valuation multiples.
This would appear to be grounded on hope, rather than fact, as previous periods of historically low yields on high-quality bonds, have always been accompanied by ratios that value stocks for their current dividend income, and little potential for future capital appreciation – a fact that was more than apparent in the early-1950s than used perversely to support bullish opinion today.
It should be clear that the idea that US stocks are cheap rests on premises that are wholly unreliable in an historical context. Perhaps there is value to be found in a global stock market index that excludes the world’s largest economy.
The data do not have as long and rich a history as the US, but the conclusion is much the same – investors should not expect long-term real returns in the years ahead that come anywhere close to that which became conventional wisdom in the post-1945 era.
The professional investment community advocates a bullish tilt to stocks, even though valuations suggest otherwise.
Perhaps they have no choice, because valuation outs over long horizons, and their own short-term bonus schemes alongside the myopic demands of clients, ensures that they will always be propagators of bubbles, and not proponents of value.
Serious value investors know better – valuation matters.
