Equities: the Valuation Puzzle
Years of low returns in store
It has become an article of faith for a generation of westerners that the best place to put their money is in equity markets. Yet only a minority of investors can consistently enjoy superior performance: those luckier or better informed than the majority. Once everyone believes in the "cult of equity", the creed will no longer be true. The potential for outperformance will have vanished.
Historical experience seems to justify the superiority of equities. In his influential book, Stocks for the Long Run (McGraw Hill, 1998), Jeremy Siegel of the Wharton School notes that US stocks have returned a healthy 7 per cent a year over inflation, on average, for the past two centuries. Amazingly, between 1926 and 1997, US stocks outperformed bonds by 7 percentage points.
UK equities have also outperformed bonds by some 6 percentage points since 1918. Again, between 1970 and 1997, equities gave better returns than bonds in all important markets: the differences were 6 percentage points in the Netherlands, 4.7 percentage points in France, 4.4 percentage points in the US and UK, 2 percentage points in Japan and 1.6 percentage points in Germany.*
Several investment gurus have used this experience to argue that equities have been "too cheap": shares have offered returns greater than can be justified by the risk of holding them. From this they also conclude that current valuations, high though they may be by historical standards, are in fact reasonable. After two centuries of exaggerated caution, investors have simply come to their senses.
This highly convenient theory provides a justification for the current extraordinarily high valuations, on virtually any historical measure. Wall Street has regained all the ground it lost during July and August, putting the trailing price-earnings ratio for the Standard & Poor's Composite 500 at 31, a historic high (see chart). Asia may be crumbling and Latin America stumbling. But, for bears the performance of western stock markets has, yet again, been humbling.
The question then is whether those historic gaps between real returns on equities and bonds can indeed justify current valuations, particularly those in the all-important US equity markets. The answer is "almost certainly no". But if those valuations can be justified, that also means lower returns in future because the risk premium has shrunk.
Paradoxically, therefore, the only way to justify the exceptionally high returns on equities of the past 15 years, shown in the chart, is to accept that the future returns will be lower than normal. Only then can current prices be sensible. If returns are to be in line with historic experience, however, equity prices must first tumble.
The gap between returns on equities and bonds is commonly called the equity risk premium. This is a bit of a misnomer since what we observe is certainly not what people initially expected and desired - it rarely is. The notion of a risk premium applies to expectations, not outcomes. The two coincide only if what occurred was what was expected. In practice, this is quite unlikely.
In an excellent forthcoming paper, Sushil Wadhwani of the Tudor Investment Corporation suggests therefore that the desired premium in the US was only about 4 percentage points over the 1926-97 period, not the 7 percentage points actually observed.** This adjustment helps make current valuations seem sensible, though not enough.
Economists often approach the question of what valuations should be using something called the dividend discount model. This states that the dividend yield, plus the expected steady state growth of dividends, should equal the real interest rate on safe assets, plus the equity risk premium. With assumptions on the first three, an implicit value can be derived for the last.
Mr Wadhwani's best guess for the premium implied at present is a mere 1.7 percentage points. (This assumes a dividend yield of 2.6 per cent when adjusted for share buy-backs, a dividend growth rate of 2.3 per cent and a real interest rate of 3.2 per cent.) The implied premium could well be far lower under perfectly plausible assumptions. But even this is evidently much smaller than the estimated desired level (4 per cent), let alone the historic performance of 7 per cent.
The apparent conclusion is that the market is chronically overvalued. Some analysts reject that because they have a strongly held belief that there should be little, if any, risk premium. Over any extended period, they argue, stocks are no riskier than the alternatives. In essence the argument that current values are justified rests on the concomitant belief that people have finally woken up to a long-standing reality.
There are several excellent reasons for not believing this.
First, as Mr Wadhwani points out, there are good reasons for thinking equities are riskier than bonds, let alone cash. Particularly in the low-inflation world that analysts increasingly rely on to justify current high market valuations, equities are certainly riskier than bonds since inflation is the biggest risk the latter face. Note also that most equity holders are middle-aged or older, and have correspondingly limited time horizons, to the extent that they are investing for their own retirement. These people cannot ignore the substantial medium-term volatility of equity prices.
Second, survey evidence strongly suggests that many US private investors are expecting unbelievably high future returns of over 20 per cent, not the lower returns implied by the theory. Furthermore, most pension funds and, for that matter, proponents of social security privatisation seem to assume real returns of 9-10 per cent, not the 4-5 per cent implied by current dividends and likely rates of profit growth.
Third, if this story were correct, equity would be cheaper than before, relative to bonds. Thus one would have expected to see the substitution of equities for debt as the chosen method of corporate finance. In aggregate this has not happened in the US. Indeed, one could argue that US corporate finance has become riskier, by substituting debt for equity, just as the theory suggests the equity risk premium has collapsed. There is something wrong here.
Fourth, for the US corporate sector as a whole the cost of capital and the return on it should be equal. Thus if the cost of equity is lower than ever before, so must the return be. But it is a favourite belief of Wall Street that the return on capital is now permanently higher than it used to be. Note that this is inconsistent with the view (also widespread on Wall Street) that the cost of capital is now permanently lower. One can believe in lower costs of capital or higher returns on capital, but not in both at the same time, at least not as a proposition about the long run.
There are, therefore, fundamental reasons for doubting the proposition that what is driving the market is indeed a fundamental re-evaluation of the riskiness of equities. Perhaps aware of this, many analysts rely on ad hoc explanations instead.
They note, for example, that low inflation tends to raise equity valuations, perhaps because it lowers macro-economic risk and improves the quality of corporate earnings. But, as Mr Wadhwani again notes, low inflation has not done much for Japan. It did not do much for the UK between 1700 and 1939 either, he argues. There is, above all, no fundamental economic reason why low inflation, which is to do with nominal or monetary values, should have a large and permanent effect on equity valuations, which concern real magnitudes.
Also important in underpinning valuations have been some startlingly optimistic earnings forecasts. There is now a severe recession in about a quarter of the world economy and strong deflationary pressures worldwide. Shares of profits in US gross domestic product are also already close to the levels reached in the mid-1960s, having doubled since the early 1980s. Yet the consensus forecasts for growth in corporate earnings over the next two years are 17 per cent and 13.5 per cent, respectively. Anything is possible but who can seriously believe this in a fully employed economy with an underlying growth rate of no greater than 3 per cent in real terms and modest inflation?
The conclusions are simple enough. It is conceivable (if highly unlikely) that the desired equity risk premium has fallen to unprecedentedly low levels. If true, this also means that prospective returns on equities and the cost of equity funding are far lower than in the past: 4-5 per cent real returns in the US (and UK) would seem about right.
Alternatively (and far more plausibly), this is a great big bubble. If so, what has blown it up is the experience of extraordinarily high returns over 15 years. These returns were produced by a return to normality on inflation and shares of profits in GDP and were further multiplied by the rising values placed on the improved underlying earnings. A generation has learned that it is always right to be in the market. This is the explanation for the extraordinary resilience of market values. It is not that people now expect lower returns in future, but that they expect a continuation of the extraordinarily high returns of the past.
Whether one buys the market, or sells it, depends above all on where one stands on a relatively simple question: do investors expect a continuation of the last 15 years of exceptional performance or a massive reduction in returns? If your answer is the first, sell.
*Equity-Gilt Study 1998, Barclays Capital
**The US Stock Market and the Global Economic Crisis, Sushil Wadhwani, National Institute Economic Review, London, forthcoming
The Financial Times, Dec. 16, 1998 |
