Moody Blue

Look around at the broader market and economic landscape, and there’s a good bit to feel uneasy about.  In Europe, even though sovereign debt/yield troubles have been under control of late, very few policymakers, or investors for that matter, feel that we're out of the woods.  Spain continues to engage in a convoluted dance with the ECB.  In the US, approximately 65% of S&P 500 companies reporting so far have missed revenue estimates; year over year earnings are looking at a second flat to down quarter.  The election and the subsequent fiscal cliff situation continue to inject broader uncertainty.  In China, manufacturing indicators continue to hang around in worrisome territory, though in fairness companies and economists feel that there may be a light at the end of the tunnel.  Now, Japan may have its own fiscal cliff to worry about.  

Despite all the negatives that have piled up over the past quarter or two, the market keeps pushing higher, this week's corrective pullback notwithstanding.  The MSCI EAFE has rallied over 15% from the early summer low.  The S&P 500 in the US has been on a similar trajectory.  

Here's what's been particularly interesting.  Normally an improvement in market price action leads to a commensurate improvement in various market sentiment indicators.  While they aren't perfect, generally indicators such as the AAII bull/bear and the put/call ratios in the US have provided decent contrarian signals.  Almost across the board, market sentiment indicators that we follow here are at or near the lows witnessed last fall.  For instance, 4-week average bullish levels in the AAII survey are currently a standard deviation below normal, while the 4-week average of bears is running a standard deviation above normal.  Similar negative readings are evident in the ISE Sentiment Index, which measures the numbers of calls traded per 100 puts in the options marketplace.  During the summer correction this year, sentiment was worse than last fall in several instances.  

Sure, at various points this year during rally periods, indicators have perked up.  The first sign of trouble, however, sends investors almost immediately into a psychological rut.  In the past, levels such as those recently seen have been associated with stabilization in past market price action.

This doesn't necessarily mean that everyone should get out there and load the boat with equities.  But, the quick downward shifts in psychological momentum whenever headlines and market action gets a little hairy seems to indicate there could be some additional upside in equity markets and that a “wall of worry” is in place and ready to climb.  It's never time to get complacent, but markets generally seem to move, rule of thumb, in the direction that causes the most pain to the greatest number of investors.  Sentiment among investors is still seemingly dour.  The pain trade, at least in the short run, would seem to be markets that grind higher.  Below, we've included some of the relevant sentiment indicators.

AAII Bull Bear Data
Source: American Association of Individual Investors, Bloomberg

Bullish levels in the US have remained under historical averages all summer and fall, despite the fact that markets have marched steadily higher. Bearish levels, except for a few weeks following the QE3 announcement have been elevated, significantly so as of late.

ISE Sentiment Indicator
Source: International Securities Exchange, Bloomberg

BNP Paribas Europe Love-Panic Market Timing Indicator
Source: BNP Paribas, Bloomberg

Not necessarily in “total panic” territory relative to where markets were in early 2009, but sentiment overseas remains subdued and near last fall’s lows.

On Margins...

One of the more remarkable stories since the beginning of the "Great Recession" and the subsequent bout of sub-trend growth has been the ever upward march of corporate profitability in the United States.  S&P 500 earnings going into this earnings season are at or near all-time highs and should remain there this earnings season despite what will probably turn out to be another mediocre quarter in terms of quarter over quarter and year over year growth.  Profit growth in the US has received one heckuva tailwind from one source: margin growth.  Corporate profits as a percentage of nominal GDP are now at or near all-time highs (see chart).

Bureau of Economic Analysis, Bloomberg, and IronHorse Capital

Except for the hiccup associated with the 2008/2009 economic crisis, margins have remained high for the past decade.  Of course, companies in the US have been highly effective in terms of doing more with less over the past several years, increasing the productivity of existing workers, cutting costs, and improving manufacturing processes, among other things.  Increasing global, ex-US, sales growth among US companies has most likely helped significantly as well.  Certainly one of the biggest tailwinds has been the fact that labor costs have been subdued over the past few years due to several factors.  High unemployment, hence a high supply of labor has kept wages subdued as workers compete with one another for open jobs.  The continued opening up of global labor pools has also contributed to this phenomenon.  Vast improvements in communication technology and the sophistication of global supply chains have allowed companies to move lower skill work to other countries.  Increasingly, companies have found opportunities to move higher skill service and analyst positions overseas.
 

At some point, however, this well will run dry, maybe sooner rather than later.  As seen below in the chart created by the Cleveland Fed, the Labor share of national income, which had remained in a relatively tight range for about 50 years, began to fall dramatically in 2000.  

Federal Reserve Bank of Cleveland

This provides a stark graphic representation of some of the forces described above.  It's no coincidence that this represents a mirror image of the profitability graph.  Some of the declines represented below are structural and long-term in nature; more than likely the long-term trend has downshifted.  Even so, this has been a mean reverting series as has the profit margin series.  At some point, for whatever reasons economic and/or political, this decline will be arrested and begin to upshift and corporate margins will begin to come back to earth (and will probably overshoot to the downside at some point in the future).  

Profit margin peaks and troughs have been very closely associated with peaks and troughs in the S&P 500 over the past 50 years.  This earnings season and beyond, these forces warrant close observation by domestic investors.  When margins have broken to the downside in past episodes, usually the retreat was swift.  

Animal Spirits

In last week's blog installment, we talked about a simple "back of the envelope" method for estimating future market returns.  A key component to that equation is the "animal spirits" component, i.e. P/E expansion and contraction over time.  As demonstrated last week, P/E expansion and contraction have an outsized impact on annualized returns through a cycle.  Even in environments with robust earnings and dividend growth, P/E contraction and reversion to the long-term mean (or beyond) can negatively overwhelm any of the positives.  The converse holds as well.  In our 2000s example last week, P/E contraction represented a 5% to 6% annualized headwind to market performance.  

What causes P/E ratios to increase or decrease, sometimes to absurdly overvalued or undervalued levels?  We'll try to address that briefly in this post.  First, a few housekeeping items.  When referring to P/E we generally prefer a 5 or 10 year normalized P/E.  This is simply an average of prior 10 year or 5 year earnings.  Because earnings can be quite volatile intra-cycle, using normalized earning smooths out the bumps and helps us get a feel for the long-term trend.  While normalized P/E ratios aren't appropriate for making short-term speculative market timing calls (markets can stay irrational longer than you can remain solvent!), normalized P/E ratios have a strong statistical relationship to longer term future returns.  

Markets have experienced normalized P/E ratios as low as 4x to 5x (during the height of the Great Depression) and as high as 40x during the late stages of the 90s bull market and tech rally.  No two market periods are ever exactly the same, but there are a few factors that figure predominantly in multiple expansion and contraction.  Sometimes one factor dominates.  In other situations, all factors or a combination of factors affect P/Es.

The first generally recognized factor affecting P/E contraction or expansion: expected inflation rates.  In general, markets prefer inflation levels that aren't too hot and aren't too cold.  Crestmont Research has posted a copious amount of research addressing this factor and has summed up the relationship with their "Y-Curve" chart:

In sum, the Y-Curve shows us that markets like environments where inflation expectations run about 1% to 2% per year.  As inflation increases, P/Es contract.  Markets dislike deflationary environments as well.  Why do inflationary and deflationary environments affect animal spirits?  It comes down to understanding that current market prices reflect the sum of "discounted" future cash flows.  Cash flows are discounted back at the required rate of return investors demand to compensate for risk.  If that perceived risk rate is higher, the value of those future dollars is less in today's dollars, resulting in a lower current price.  Conversely, a lower required rate of return, i.e. lower perceived risk, means the discounted future cash flows are worth more in current terms, hence a higher price.  In inflationary environments, perceived risk is higher, and investors require a much higher future rate of return to compensate for inflation risks.  Even though nominal earnings presumably go up in inflationary situations, the increase in future earnings is not enough to compensate for the future risk, thus depressing current prices.  Deflationary environments generally accompany some sort of economic disruption.  Required rates of return may not reach levels seen during inflationary environments, but perceived risk is elevated.  At the same time earnings are either not growing or outright contracting.  Take elevated risk perception and expectations for zero growth in cash flows, and the value of those future cash flows in current dollars is lower.  

Another potential factor affecting P/Es is perception of general economic and/or political volatility.  This can be country specific, region specific, or global.  The general effect is the same.  Increased perceptions of risk and volatility increase the required rate of return.  In an extreme example, a coup in a particular country would certainly increase risk perception and required rates of return.  Or, downshifts in market thinking in terms of future economic prospects reduce the perception of future cash flow levels.  As we discussed above, negative changes in cash flow and risk expectations lower the current or present value of future cash flows.  

Finally, major paradigm shifts among investors can lead to expansion of P/E levels, often to unsustainable levels.  Generally, the transmission mechanism here is increased/outsized expectations for future earnings and cash flows, all other things being equal.  During the 1960s, excitement surrounding the "Nifty 50" created feelings that there would be significant potential for outsized future cash flows.  More recently, the tech/internet boom in the late 1990s (and the housing boom last decade) proved that expectations of future cash flows/profits can get way out of hand in terms of historical reality.  Investors in 2000 were convinced that the internet boom would create a "New Normal."  Home buyers in 2005 and 2006 near the end were absolutely convinced home prices could never decline.  

Whatever the situation, we know long-term earnings growth has been consistent over time and that earnings growth has tracked nominal GDP growth closely.  And, we know from experience that humans are prone to herd behavior and extreme over and under exuberance.  Around the world, investors tend to overemphasize both good and bad news.  No matter the factors driving P/E expansion and outsized market returns, at some point the over exuberance reflected in elevated P/Es reaches its natural ceiling.  Heightened perception meets cold reality, expectations are reset, investors act accordingly, money exits, and multiples return to levels more befitting of the long-term trend.  In 2000 and 2001, investors quickly came back to earth as expected earnings and cash flows didn't materialize in the tech sector to the extent implicitly reflected in multiples.  Companies underlying the market indices were never going to "grow into" those expectations, at least not in the short or intermediate term.  On the other hand, with depressed valuations, at some point psychology becomes far too depressed relative to historical trend.  The early 1980s represents the last time we saw sustained single digit normalized P/E ratios.  This was a period marked by high inflation and interest rates, political certainty, and economic malaise.  Predictions of eternal decline and malaise proved to be far off the mark.  Investors with patience and an understanding of longer-term cycles were rewarded by buying equities in the early 1980s when many others were shying away.  

As individual and institutional investors, its important to understand that P/E cycles have been consistent over time in terms of moving significantly above and below mean levels and that multiple expansion and compression is an important part of understanding returns.  Identifying the factors driving expansion and contraction is important, as is understanding that investors tend to believe that trends will continue indefinitely into the future, despite evidence that the factors driving expansion and contraction will eventually reverse course.  

Back of the Envelope…

There's a certain amount of "behind the curtain" mystique accorded to the equity market analysts, fund managers, and market talking heads that constantly bombard us with information on various business news channels and on the pages of the leading news publications.  What should you buy now?  What's the hottest stock?  What will future market returns look like?  Where should I allocate in the US or around the globe?  This fills a lot of space and does a heck of a job of pushing both institutional and individual investors in many different directions.  I suppose we at IronHorse can be judged guilty considering we send out investment outlooks each month and write these blog posts.  Frankly, judging future returns (not future volatility, but future returns, an important distinction) in just about any region can be pretty easy.  Vanguard founder John Bogle nailed it in a speech last year to the NMS Investment Management Forum.  Basically, you can become the prognosticator of the decade by using three simple numbers to come up with ten year annualized returns: expected nominal GDP growth, dividend yield at the beginning of the decade, and multiple expansion/contraction potential.  Multiple expansion/contraction sounds confusing; actually the concept is pretty simple.  Take a long-term P/E measure like the 10 year normalized P/E (a P/E ratio using the average of trailing 10 year earnings).  Determine how far away P/E is from the historical mean percentage-wise and divide it by 10.  Add the three numbers together and you get the expected annualized returns for a particular market.  For instance, if you expect nominal GDP growth to be 5% per year, the starting dividend yield is 2.5%, and the market is 50% overvalued.  You'd expect annual total returns over the ensuing decade to be approximately 2.5% per year (5 + 2.5 - 5).  

Why should this work?  Well, over time total stock market returns are derived from earnings growth, dividends, and animal spirits, or lack thereof.  Over a long period of time, earnings growth should roughly track nominal GDP growth.  It's not perfect, but it's pretty close.  Since 1930, compound annual nominal GDP growth in the US, for instance, is approximately 6.5%.  Using Robert Shiller's public database of earnings, compound annual earnings growth over that time is just south of 6%.  The average dividend yield over that time period has been approximately 3.5%.  Add 6.5% and 3.5%, and you get 10%.  Compound annual total returns for the US markets since that time are approximately 9.8%.  Again, it's not exact, but pretty darn close.  Focusing in on specific time periods, we see there are times, like the late 1990s in the US, where investors get way ahead of themselves, the "animal spirits" go crazy, and market valuation multiples shoot through the roof.  In 2000, the 10-year P/E was astoundingly around 40x.  There are other times, like the early 1980s in the US, where investors want nothing to do with stocks; single digit earnings multiples reflected this.  Reversion to the mean takes hold and provides either a headwind or a tailwind.  

How did that work out last decade?  Almost perfectly, in fact.  Compound annual nominal GDP growth in the US was 4.1% between the end of 1999 and the end of 2009.  The dividend yield at the beginning of the decade on the S&P 500 was 1.16%.  The 10-year normalized (trailing 10 year average earnings) P/E was 62% overvalued (43.7x vs. a long term average of approximately 16.5x).  Add the numbers together, 4.1 + 1.16  - 6.2, and you get a compound annual number of -0.94%.  What was the actual number for annual total returns over the past decade?  -0.4% per year.  Very, very close.  The point isn't to hit the number exactly.  The point is to understand whether conditions are favorable going forward, or unfavorable.  If one's GDP forecast were a percentage or two higher than the numbers that actually arrived, the investor still faced a pretty discouraging decade ahead.  The multiple contraction headwinds going into the 2000s would have been incredibly hard to overcome no matter the overall economic conditions.  Animal spirits broke out in a big way during the 1990s and investors paid the price during the ensuing decade.

So where do we stand now?  What does the next 10 years look like?  In the US, the current dividend yield is approximately 2.5%.  Let's say this decade economically will mirror last decade in terms of subaverage annual nominal GDP growth of 4%.  The current market multiple is 22x, or approximately 25% above the historical mean.  2.5% + 4% -2.5% = approximately 4% per annum nominal total returns over the next decade.  Put on your  optimism hat and add 2.5 percentage points of nominal GDP growth per year, and the US forecast would come in at 6.5%, about 3% per annum short of the long term average.  Such is the nature of potential multiple contraction headwinds.  On the other hand, apply the analysis to emerging markets, which are currently trading at approximately 13.5x, or approximately 22% below what we'll consider a viable long-term average.  Let's be really conservative and accept that nominal GDP growth in emerging markets slows to a crawl relative to the recent past.  In this case, let's peg them with 5% annual nominal GDP growth, not much above the US.  The dividend yield in emerging markets is approximately 2% right now.  Add 5% + 2% + 2.2%, and you get 9.2% per annum.  Even under very conservative assumptions, an investor is looking at potential double digit returns in emerging market equities.  Last but not least, apply the analysis to global, ex-US, EAFE markets.  Nominal GDP growth should remain constrained, maybe around the 3% level (implies real GDP growth somewhere around zero).  The dividend yield is around 3.5%.  Valuations are roughly in line with historical mean.  3% + 3.5% + 0 = 6.5%. total annualized return, in line with the optimistic US scenario.  

What's the back of the envelope story?  First, understanding and estimating future returns doesn't require a ton of computing power.  And, global stocks seem to provide more promise over the next decade or so than US stocks.  We'll see what happens!