Across the Valley or Over the Hill
The Risk/Reward Ratio of Market Timidity
On October 25, Alexander Paris of Barrington Research, wrote “Still Looking over the Valley”, a report that handily recapped the views of the majority which still believes in a “soft landing” of the US economy, i.e. a slowdown that would fall short of a recession.
Two days later, the government announced that the economy’s growth in the third quarter had come in at 1.6% (annualized), well below consensus expectations. The Capital Spectator, observed: “the economy has little room for further ‘deceleration’ without triggering the ‘R’ word”.
But wait! Joe Carson, at Alliance Bernstein, immediately added that, in fact, the growth rate should have been 0.9%. “The 1.6% number was the result of a statistical fluke which yielded an unexpected increase in auto production last quarter, in spite of announced cutbacks by Ford, GMC and others…” (John Mauldin’s “Thoughts from the Frontline”, October 27, 2006).
That progression is not altogether unusual. Comstock Partners had already reminded us that “all recessions look like soft landings shortly before or after they begin” (“Soft Landing: Why Fight the Odds”; 9-21-06)
How relevant is all this to the stock market? In truth, not very. Investors and their media pushers can continue to gesticulate at every ripple of the economy, but Ed Easterling, founder of Crestmont Research, reminds us in his book Unexpected Returns that economic growth and stock market performance part ways more often than not.
OK, you say. But what about profits? Doesn’t their progress determine how stocks will be doing?
The first answer to that question is that we should not expect too much help from corporate earnings in coming years.
John Hussman, President of the Hussman Investment Trust, often reminds his readers of the importance of measuring earnings and stock returns from peak to peak. This will prevent investors from developing unrealistic expectations – especially around earnings and market peaks or troughs, when they become most influenced by recent trends and lose all historical perspective.
The fact is, despite occasional bursts of
profitability, US earnings have never grown by more than 6% per annum from peak
to peak. (Incidentally, I believe that the same holds true in
Confirming the sense that we are near a peak in profitability, Jeremy Grantham, Chairman of GMO LLC, warns that market analysts fail to incorporate in their projections the fact that profit margins are a historical high. Because “profit margins are provably the most mean-reverting (let’s say cyclical) series in finance” this does not bode well for the future growth of earnings much above the growth rate of the economy. (Chart from his April 06 newsletter.)
As Ed Easterling points out that, in more than half of the past 55 years, earnings have changed—up or down—by more than 10%. Therefore, double-digit growth rates or declines are more often the rule than the exception. But “average rarely happens: there are significant cycles and volatile swings in earnings that average to a growth rate of 6%.”
So, the growth of earnings, after being well above average in recent years, could very well fall below its 6% historical trend in the coming decade or so – probably as a result of more, longer or deeper profit setbacks between profit surges.
The second answer to how earnings growth might affect the stock market in coming years is even more disappointing: profits are not the main driver of stock prices either. For example, the fastest earnings growth of the past 55 years took place in the 1970s, a decade when stocks showed almost no progress. Conversely, in the 1990s, as earnings grew by a mere 5.4% a year, stocks surged at a 15.4% average annual rate.
Au secours, P/E ratio! But what is a P/E ratio?
A company’s stock price is made up of only two variables.
One is “fundamental”, that is the company’s
earnings and we have stated our view that investors should not hope for too
much on that front, at least in the medium term;
The other is largely psychological, measuring what investors are willing to pay for one dollar of earnings. It is called the “price/earnings ratio”, or “ P/E.”
The following table, which accompanied a recent interview of Keith Wibel, of Foothills Asset Management, put some meat on his argument that: "Over 10-year periods, the major determinant of stock-price returns isn't growth in corporate profits, but rather changes in price-earnings multiples.” (Barron’s; 8-29-05)
|
|
S&P 500 |
|
||
|
|
Annual Change |
P/E Ratio |
||
|
Decade |
EPS |
Index |
Beginning |
Ending |
|
1950s |
3.9% |
13.6% |
7.2 |
17.7 |
|
1960s |
5.5 |
5.1 |
17.7 |
15.9 |
|
1970s |
9.9 |
1.6 |
15.9 |
7.3 |
|
1980s |
4.4 |
12.6 |
7.3 |
15.4 |
|
1990s |
7.7 |
15.3 |
15.4 |
30.5 |
|
2000s* |
4.1 |
-3.8 |
30.5 |
20.7 |
*Through Dec. 31, 2004
But, if what really moves stock prices over periods of a decade or more is the P/E ratio, what, in turn, moves price/earnings ratios?
Not encouragingly, Bob Prechter, Wall Street maverick and author of The Wave Principle of Human Social Behavior, argues that it’s all in investors’ heads: “Value is not inherent in objects, but pertains only when human beings desire something”. Otherwise, he asks, how do you explain that President John Kennedy’s rocking chair sold at auction for $453,000 in May, 1996 and for only $23,000 in March 1998, less than two years later? Similarly, he continues, “investment prices are governed almost entirely by the shifting mental states of those bidding and asking in an auction market”.
As evidence, Prechter points out that, just in this century, the Dow Jones Industrial Average has yielded as little as 1.5% in dividends and as much as 17.4%. The Dow’s dividend yield has also fluctuated between 0.25 times and 4.9 times the yield on Treasury bonds. Prechter concludes that these huge differences are due to one thing: people’s opinion about the capital gain potential of stocks.
Here, I should add a nuance. In gauging the long-term return potential of stocks, investors do seem to pay attention to at least one competing return: that on US Treasury bonds, which are considered riskless, if held to maturity. Of course, they are only riskless if you consider that inflation (which erodes the value of money) is not a risk. But that’s another matter.
As evidence of the influence of bond interest rates on stock returns (and on their main determinants, P/E ratios), I offer the following chart. I do so with apologies to its author, since I lost all reference to the source.
The graph (which ends in 2005) does not look particularly encouraging for the future progress of price/earnings ratios if, indeed, they are the primary movers of stock prices. In the twenty-odd years before 1982, as bond rates rose, the S&P 500’s compound appreciation was a mere 2.9% per annum. When bond rates declined, in the following twenty years, the S&P 500 galloped at a compound rate of 10.5%. (Note that dividends are not included.)
Looking at the chart, would you bet that the next twenty years will look more like the last ones or the two decades before 1982?
Whatever drives price/earnings ratios, investor optimism and pessimism clearly are primary factors. All else being equal (perhaps the most dangerous phrase in economics), optimistic investors will pay more for a dollar of corporate earnings than pessimistic ones. And, in paying more today for a dollar of earnings, they forego some of the future gains that would come from a rising price/earnings ratio.
Keith Wibel’s
table, shown earlier to illustrate the importance of price/earnings ratios in
stock returns, also brings to light another interesting (though logical) fact: the higher the stock market’s P/E ratio at
any given point in time, the lower its return will be in the ensuing decade
(and, of course vice-versa).
A number of
respected strategists, such as those at ISI Group and Bridgewater Associates,
have argued that price/earnings ratios already have declined enough from their
prior highs (in 1999-2000) to justify at least a worthwhile stock market rally.
David Kotok, of Cumberland Advisors adds in his
October 21 letter that during the last century in the
But, as can be seen from the chart below, the current P/E
ratio of the S&P 500 index, at around 17, has only returned to its 50-year
average, from unprecedented high levels in the early 2000s.
“No longer expensive”, you might say. But in his book Just One Thing, John Mauldin cites a finding by Michael Alexander, himself author of Stock Cycles: “Valuation cycles in secular bear/bull markets run anywhere from eight to seventeen years… In the past, a secular bear market never stopped in the middle of going down; it always went to the full extent of the pendulum (emphasis added). There will be bull market rallies during a secular bear market, but the next secular bull market will begin… when very few want to talk about or own equities anymore.” Judging by the table above, we should not expect a new, major bull market until price/earnings ratios have fallen toward 10.
The current stock market conundrum, it seems, can only be solved through: 1) a very sharp drop in stock prices; 2) marking time to let earnings catch up with stock prices; or 3) some combination of the two.
As often with analyses that rely on secular history and common sense, translating thoughts into specific actions is tricky – especially in terms of timing. But, in view of all the above, the real question at this point is: “How much do we stand to miss by being cautious about the current market?”
Here, we can get some help from John Hussmann, President of the successful Hussmann Investment Trust, as well as from The Chart Store.
In Temporary Versus Permanent Returns (10-16-2006), Hussman observes: “Even barring a full-fledged bear market, it's notable that the Dow has now gone over 900 trading days without even a 10% correction. The current advance is among the 5 longest uncorrected advances on record”.
The Chart Store, for itself, lets a picture speak a thousand words:
The current advance is clearly getting long in the tooth. My feeling is that it can’t hurt too much to wait for the next correction which, at worst or at best (depending on which side of the fence you are sitting), should bring us back to current stock market levels – or lower. By that time, we might be seeing more clearly into the present investment conundrum and decide whether we want to look across the valley or over the hill.
François Sicart
(in
October 30, 2006
New York, NY 10019