Monday 31 August 2015

Why Shares are too Expensive. And, while we're at it, is the idea that shares always out-perform partly just a historical anomaly?

To start, a disclaimer... this is not a suggestion to trade, merely an observation on the economy and what it should mean for share prices. There is a reasonable chance that I am wrong; I invite you to look at the arguments and decide. And even were I correct that prices are too high, it does not mean that they will come down. In fact they can get a lot higher because, to paraphrase the great economist Hyman Minsky, whenever the market is too high, people are prone to get a little over-excited.

People have been arguing for a while now that shares are too expensive against their historical valuations. Various metrics are used to define this. For example, the CAPE Shiller ratio looks at the price of shares against 10 year trailing earnings. Historically US shares have traded at a median of 16 times earnings. In the past valuations have reverted to a multiple 16, but it is difficult to time this; in the dot com boom it reached almost 45. At the moment the multiple is roughly 25. This suggests that the market would need to drop by almost 40% in order to be fairly valued.

Nonsense, the bulls say. This model is irrelevant. Have you not seen what has happened to government bond yields? A thirty year US treasury now only pays you around 3% per year. The short term bonds pay almost zero. Stocks are cheap because there is nowhere else to get a good return. Central bank action will always support asset prices and they'll just keep printing more money. Even a mediocre return is better than nothing, and stock prices reflect this.

I believe that shares are substantially overpriced based on any normal return expectation. There is an idea that shares always perform well in the long term; this may be true in the very long term but a period of very high growth followed by a series of one-off changes have led to large rises in share values over the past 80 years and these are unrepeatable. I will discuss all this in the rest of the post.

First, the share valuation model. For those unfamiliar with corporate finance models, a share can be valued by taking the sum of all of its future dividends and discounting them to the present. This means that if you will expect to receive £100 in dividends next year, you will value it slightly less than if you had £100 now.

There are two components of this discount. The first is for the interest you could receive if you invested in a risk-free (in most cases) government bond. This means that you need to receive at least the rate of interest you could have got for no risk. The second component of this discount rate is called a 'risk premium'. It is the extra return that you need to receive for taking risk with your money. If one only receives the same as the government interest rate, why would anyone make risky investments? In the recent past the risk premium for U.S. stocks could be reasonably said to be around 4%. So people invest in stocks with the expectation of receiving the risk free interest rate plus a risk premium.

As I show here, in relation to the UK, the total amount of debt has skyrocketed over the past 45 years.  This means that the total gross wealth in financial assets (not including property) has gone up from around 4x GDP to around 13x GDP in the UK (these are approximations). Similar trends are observed internationally. There are therefore a lot more savings than there were before. A savings glut, in fact (which is the same as a debt glut but viewed from the other side). For this reason, I would argue that the risk premium should reasonably be a lot lower than it has been in the past - maybe 2%. This would mean that share prices should be a lot higher than they would be with a 4% risk premium. I am taking this into account and I say that, even despite this, equities are now too expensive.

From here on, I will be looking at the US stock market, specifically the S&P 500 index; the most traded share index in the world.

Since 1945 share prices have been in one long bull market. They have been going up almost relentlessly. This leads to the idea that shares always out-perform bonds or cash in the long term. As I say, this may be true, but in the time period we have seen a number of important changes that have led to one-off increases in share prices.

  1. The reduction in government bond yields - 25 years ago a 30 year government bond paid 8%. Now it is closer to 3%. 
  2. The reduction of risk premium required - in 1990 I calculate the implied risk premium using my dividend valuation model to have been around 2%. Now I calculate it to be 0%
  3. Corporate profits as a share of GDP are at a high since 1945. In fact, the share has more than doubled since 1990. This would mean, all things being equal, a doubling in the fair value of shares.
These three effects would account for approximately a 20 fold increase in the value of shares since 1990. In fact the rise has been only around 6 fold.  As of 1990, the  S&P 500 was trading at around 350; at the time of writing (Aug 15) it is around the 2000 level.

Had these three one-time changes to risk preference and corporate rent-seeking ability not occurred then the stock market would actually have gone down considerably since 1990. 

Since 1990, owning the shares in the S&P 500 would not have been better than owning a portfolio of 30 year bonds. This is despite the doubling of corporate profit share to GDP and reduction in risk premium. This really highlights how poor equities’ performance has been since 1990 (relative to bonds) - and how the great fall in bond yields has managed to disguise this. Perhaps this has convinced investors that equities have a natural right to perform well in the long term.

The reason for this relative under-performance of the S&P 500 has been the performance of nominal GDP.

If the proportion of corporate profit to GDP remains the same, then corporate profit can only grow with nominal GDP. This is an extremely important point that many analysts appear to miss when making earnings growth projections.

Between 1945 and 1990 nominal GDP growth averaged around 8% per year. This means that total profits could be expected to grow by around 8% per year. In this period, there would be every reason to think that shares would keep increasing in value. However, between 1990 and today, GDP growth is closer to 4.6% PA. And in the current period of secular stagnation we may only be able to expect around 3.5%. In fact since 2008, we have averaged 2.7%.

Taken in conjunction, the change in the expected nominal GDP growth from 8% to 4.6%, along with points 1-3 above can account for the change in value of the S&P 500 since 1990.

Since 1-3 are one-off events, I would argue that there has actually been no evidence since 1990 that stocks are better than bonds in the long term, despite the apparent 6 fold increase in price.

So going forward, will shares outperform? I use the discounted dividend model above with the following parameters:

o Nominal GDP growth prediction of 3.5% per year
o Disruption rate set at 2%
o Dividend growth, g = Nominal GDP minus disruption
o Discount rate, r, of the US treasury 30 year yield (approx. 3%) plus 2% risk premium, giving r = 5%

By ‘disruption’ I mean that if one held a portfolio of all the stocks in the S&P 500, each year, 2% of profits will go to new companies that we did not already own shares in. In other words, if one bought the whole S&P 500 index today and held the shares for 30 years, one would only have shares in 55% of the S&P index at that future time. The index rebalances for new participants, but there is friction as it does so.  We assume that corporate profit share does not increase from this post-war high level, and that risk premiums and risk free rates do not decrease further from these all-time lows.

How realistic is this pricing model? Looking at the actual  performance of dividends against nominal GDP we can find the following. Given a) the increase in nominal GDP between 1990 and today and b) the share of corporate profit rising from 4.2% to 10.1% of GDP in the same time period, then we would expect dividends to rise by around 8.5% per year. In fact they rose by about 6.5% per year which accounts for the 2%  'disruption' discussed above. This means that a nominal GDP model for modelling dividend returns is not unreasonable empirically (as well as it being an economic identity).

So this pricing methodology has held well in the past. Now, it is dependent on the assumptions put in of course. All of these assumptions can be changed and all affect prices considerably. Maybe nominal GDP will be higher than 3.5%, maybe lower. Maybe corporate profit share will go up, maybe down. This is why evaluation of fair value is so difficult.

However, using what I consider to be the reasonable assumptions above, the only way that I can get that shares are fairly priced is by assuming almost a zero risk premium. This is absurd and can not continue indefinitely. 

With a risk premium of just 2%, I get that fair value is 40% lower than the current price. Or the S&P at around 1200. This actually broadly agrees with CAPE Shiller.

This is not to say that prices will definitely go down. They could just stay roughly where they are for many years before fair value catches up. But the market tends not to work like that and this is why I believe that, despite central bank intervention to support share prices, we will still see a large correction.

According to this model, calculated using a 2% risk premium, share prices have been overpriced since 1990 (with the exception of a short period in 2008-09).  The worst period was at the height of the 2000 dot com bubble where they were 300% overvalued. Stocks have kept going up despite this over-pricing, because of falling bond yields.  If bond yields stop falling then we may have reached the point where gravity takes its toll.  With so many central banks at the lower bound it is arguable that they cannot repeat their asset inflation success of the last 30 years.

My conclusion is that risk free bonds are a better investment than shares at this time in the long term. For those that worry about a large printing of money to stave off disaster, and the subsequent inflationary impacts, I would suggest that inflation linked bonds may be suitable, certainly on a risk-return basis. But as mentioned before, I am not giving investment advice and caution strongly against listening to me about anything.

I believe that low interest rates have driven shares to irrationally high levels and that ultimately they should either fall by a lot, or have a long time waiting for fundamental value to catch up with the current price. We will see if I am correct.