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.