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Active investors have faced many criticisms in the past 10 years, as the raging bull market made it challenging for them to justify their pinch of salt. Passive forms of investing took the spotlight, of course, with many forms of special concoctions such as the triple leveraged ETF and other index funds. Most of the magic potions prescribed by Wallstreet scientists supported the idea that the market should do the work, and the investor should do nothing. The issue of price-to-value became unimportant, and the market was expected to direct portfolio returns even though many of the same people believed it followed a random walk. Nevertheless, data dating back to 1871 is packed with lessons that will help investors navigate the unprecedented market environment they are in today, lessons that will be examined in detail here.
Before we delve into the lessons that historical data have, let us take a step back and clear up a few concepts that will be critical to our analysis. The reader can skip ahead to the following section if they find that they are already comfortable with these concepts. The most used proxy for the price-to-value relationship is the cumulative price of all the stocks in the S&P 500 relative to the cumulative earnings per share of all the stocks in the S&P 500 - the PE ratio. Obtaining the true price of the entire market is impractical, and so we use the S&P 500 index as the proxy that best tracks the behaviour of the overall market price. The trailing earnings of these companies are used to approximate value as it is also impractical to value all the companies in the economy.
The drivers of the price-to-earnings ratio can be distilled into a few factors that are key when determining the value of an individual stock.
One of the most important lessons is the fact that over the last 154 years, the cyclically adjusted S&P 500 price-to-earnings ratio - the S&P 500 index value relative to the average inflation-adjusted earnings from the previous 10 years - has a tendency to revert to a multiple 16.6x. When the raw PE ratio is used, the S&P 500 PE ratio reverts to a multiple of 15.8x. Furthermore, the line path of the S&P 500 PE ratio crosses the historical average at least 14 times over the period, which underscores the "gravitational forces" which push the ratios back up to the average and also pull the PE ratios back down to "earth". Investors can rest assured that over the long term, the PE ratio of the average company will move towards the long term average outlined. The data also show that sometimes the convergence toward the long term average takes several years. There have been quite a few times in the past where it has taken over 10 years for the PE ratio of the S&P 500 to converge to 16.6x earnings.
Another observation is that when we superimpose a graph of recessions that have occurred in the USA - as described by the bureau of economic research - on the historical cyclically adjusted PE ratio of the S&P 500, one can clearly see that the PE ratio of the index goes up to multi-year highs in the eve of a recession. For example, in the months leading up to recessions in 2008, 2001, 1993, and 1930, the PE ratio of the S&P 500 went to 27.5X, 35.4X, 18.5X, and 28.4X respectively. These PE ratios are well above the historical average seen in the last 154 years and underscore the fact that the market occasionally prices equity securities way above fair value leading up to a recession. Of course, in the aftermath of recessionary periods, the valuation that is applied to the market notoriously goes in the opposite direction, and the market becomes significantly undervalued.
The mean-reverting nature of the S&P 500 PE presents opportunities and risks depending on how investors position themselves. At the risk of oversimplifying, this phenomenon bodes well for some value-based long-short investors such as Third Point LLC and GreenLight Capital who buy assets when these assets are priced at very low multiples, and short assets when these assets are priced at the opposite end of the spectrum. The trends outlined also have meaningful instructions on how investors should structure their expected time horizons. The market can stay overvalued for many years, and likewise, the market can stay undervalued for many years. Within this context, investors' expected return on assets should account for the historical variations in time to convergence, and the amount of leverage used should be consistent with that which allows staying power. Finally, perhaps most relevant to the market dynamics today where we are in the midst of a 10-year bull market, high past stock market returns do not necessarily mean that the market will provide easy high returns in the future.
Since the 2008 recession, interest rates ,particularly in the USA, has been on a downward trajectory as monetary and fiscal authorities increase liquidity conditions to boost economic activity. Today, the unprecedented economic situation has complicated estimates of fair value and earnings multiples. As of July 24, 2019, the 10-year US Treasury Bond yield stood at 2.048%, which is among the lowest rates seen since 1871, with the lowest rate occurring in July 2016 (1.5%). Historically, there has been an inverse relationship between earnings multiples and interest rates. For example, in the period 1879 to 1916, the 10 year US government bond yield declined from 4.20% to 3.12%, while the cyclically adjusted PE ratio increased from 16.7x to 23.2x. This particular trend repeated itself several times over the period. In times, when interest rates increased, the PE multiple also declined significantly. Since 10-year bond yields peaked at 15.32% in September 1981 when Former Fed Chairman Paul Volcker declared war on inflation, interest rates have been on a downward trend. The downward trend in interest rates precipitated a meteoric rise in PE multiples from 6.64x in the 80s to 43.0x by June 2000. Investors should recall that in 2001 the US economy went into a recession and earnings multiples subsequently declined rapidly. Over the period, interest rates also showed signs of multi-year convergence, a phenomenon that has been covered by numerous studies on the term structure of interest rates.
When one ties all the information on interest rates and earning multiples together, it becomes pretty clear that the unprecedentedly low-interest rates will likely lead to extraordinary bullish sentiments that may not be sustained. As interest rates increase back to average levels, which we estimate to be about 4% - 5%, earnings multiples could decline significantly to reflect the new paradigm. In this situation, an investor may get stuck holding on to losses until a new paradigm sets in, and multiples go back up. In the short term, however, there appears to be little concern for higher rates, as inflationary pressures have been subdued, and hawkish rate actions by the US federal reserves have been followed by a rapid fall-off in economic activity and calls for rate cuts.
There are other macroeconomic issues that have happened in recent times that could help sustain a higher price-to-earnings multiple, at least in the near term. The most topical issue is the reduction in the corporate tax rate from effectively 35% to 21%. The more favourable tax regime has had a positive impact on earnings multiples, as the amount of after-tax cashflow that equity securities produce has gone up by the amount of the tax reduction offset by the reduction in the value of the interest tax shield. The long term impact of this policy is less clear cut because the reduction in tax rates has been followed by a rapid rise in the fiscal deficit and the growth rate of the national debt. High fiscal deficits and debt levels can lead to higher interest rates later, which will certainly put downward pressure on future earnings multiples. Fiscal authorities are hoping that the tax reduction will stimulate future economic activity which will allow them to raise enough money to offset the rise in the deficit.
Today, investors are participating in an equity market that they have not seen in modern history. First of all interest rates are hovering around levels not seen in the last 154 years. We are also in what is called the third industrial revolution that is disrupting many long-established businesses and creating a disequilibrium of sorts in some markets. Protracted low-interest rates have led to a rapid increase in M&A both by strategics and financial sponsors, and in some respects has artificially raised the growth profile of many companies. In addition, market multiples have increased immensely, as the discount rate is now at historic lows. Going forward, investors should expect that current market conditions will be temporary. While inflationary conditions have remained subdued for now, this could reverse quickly given that the unprecedented accommodative environment has been in place for well over a decade. A sharp reversal of inflationary pressures could precipitate a rapid rise in interest rates, which will ,in turn, depress market multiples and valuations.