U.S. stock prices continued their upward climb through the months of February and March, and the near 30 per cent gain in just five months has seen the major indices move above the levels that prevailed just weeks before the world’s capital markets descended into freefall during the autumn of 2008.
All too predictably, the sharp reversal in the equity market’s fortunes has prompted the perma-bulls to confidently declare that the path of least resistance is up. There has rarely been a better time to buy stocks, they argue, given valuations that have seldom offered such high returns relative to Treasury bonds. Could the soothsayers be right or is this just one more opportunity to lighten equity allocations in the face of the negative secular trend that has persisted for more than a decade?
It must be stressed that strategic allocation to equities should be consistent with the output of a properly-constructed valuation model that provides a relatively reliable estimate of potential future returns. In this regard, it is unfortunate to observe that the industry appears to have learned little from the near-zero real returns earned from stocks over the past fourteen years, a disappointing outcome that stemmed in large part from overinflated valuations.
Indeed, far too many professionals continue to employ the very same techniques that failed to preserve capital so spectacularly through the two brutal market setbacks endured since the turn of the new millennium. The inability to spot trouble ahead is typically blamed on unforeseeable events but, the plain truth of the matter is that reliable measures of valuation were pointing to meagre long-term return potential well before the markets completely exposed the industry-preferred methods that lacked theoretical substance.
The price/earnings multiple is the most widely employed valuation tool, but the standard calculation is deeply flawed given the use of single-point forward-looking projections of operating profits per share. The denominator should reflect the market’s long-term earnings power and not a number that is unduly influenced by the stage of the business cycle.
In this regard, it is simply not reasonable to use an earnings estimate that incorporates profit margins that are at a multi-decade high, as is the case today, since the historical record demonstrates that this measure of profitability is one of the most mean-reverting of all corporate fundamentals.
Further, the traditional analysis calculates earnings before once-off items such as discontinued operations, extraordinary items, and the cumulative effect of accounting changes. A top-down perspective suggests this practice is dubious, since asset write-downs and once-off charges are neither exceptional nor extraordinary in an economy-wide context, but an inevitable product of competitive rivalries, not to mention the ups and downs of the economic cycle.
The historical record since Standard & Poor’s first began compiling operating earnings data reveals that the level of once-off charges moves in tandem with the economic cycle. Indeed, reported profits i.e. after write-offs, have moved to as high as 98 per cent of operating earnings during the past two economic expansions, only to drop to as little as 16 per cent during the subsequent downturn. Simply put, bad investment decisions that seemed sensible during the boom are exposed during the bust that follows.
Those of a bottom-up persuasion argue that reported profits do not represent an accurate picture of a company’s ongoing earnings power, because the write-off truly is a once-off event. However, if this argument had merit whereby one-off events are random, then one would reasonably expect the odds of a negative charge to be equal to the chance of a one-off gain.
The historical evidence however, paints a completely different picture. In fact, there has only been eight quarters over the past 24 years in which reported profits have been greater than operating earnings, and only one quarter since the first three months of 1995. Further, the gap between the two earnings measures has grown through time as the level of write-offs has increased at more rapid clip than operating profits. Needless to say, the operating number is not a true and fair representation of the market’s long-term earnings power and should be discarded.
The price/earnings multiple popularised by Robert Shiller of Yale, uses ten-year average earnings as the denominator, and the historical data demonstrate that it has considerable predictive ability. The current reading is close to 23 times, a level that has always been followed by lacklustre long-term real returns. Indeed, investors could consider themselves fortunate if they go on to earn real returns of anything more than three per cent per annum over the next ten years given current valuations.
For those who doubt the message emanating from the Shiller price/earnings model, consider Tobin’s Q-ratio, which measures the market value of equity relative to its replacement cost. The stock market is currently trading at more than 20 per cent above the long-term average, and as with Shiller’s measure, this technique suggests that investors can reasonably expect low real annual returns in the decade ahead.
The favourable stock market outlook espoused by the bulls is based not only on dubious absolute valuations, but also on the attractive yields relative to Treasury bonds. However, several academics and practitioners have shown the comparison to be a form of money illusion with no ability to predict long-term stock returns.
The bulls are back in charge, but studied analysis shows their valuation arguments to be flawed and even dangerous. As the late Humphrey Bancroft Neill, author of the 1954 classic, ‘The Art of Contrary Thinking’ observed “The crowd rides the trend and never gets off until it’s bumped off.” Investors would do well to remember that it wasn’t raining when Noah built the Ark.
Previously posted on www.charliefell.com