US Valuations are Stretched vs. ex-US...By the Numbers

It’s been several weeks since we’ve run through long-term valuation metrics and predicted values for future ten-year returns.  With markets, especially indices in the US, having corrected since mid-September, this seems to be a good time to check back in.

As we’ve mentioned several times in the past, we prefer longer-term “normalized” P/E ratios.  To come up with a “normalized” earnings number, we take an average of trailing earnings over a designated time frame.  Some analysts prefer 5-year average trailing earnings because that time period roughly conforms to a typical business cycle.  Professor Robert Shiller of Yale University has famously presented a ten-year normalized earnings number for many years.  As it turns out, Professor Shiller may have a point; 10-year normalized P/E ratios have a stronger statistical relationship historically with future 10-year annualized returns.  For the US, we’ll present both.  For the global indices, we’ll present the 5-year, owing to the fact that the amount of available earnings data for global indices isn’t as robust as the US dataset.  The point of “normalizing” earnings is to smooth out the earnings kinks that result from the ebb and flow of the business and earnings cycle.  When analyzing returns, we usually refer to “real total 10-year annualized returns.”  What does this mean in layman’s terms?  We are interested in looking at returns that include dividends (total return) and that take inflation into account (real return). 

In the United States, long-term P/E ratios still remain in heady territory.  The recent correction has made a slight dent, but predicted values for future annualized returns still remain below historical median.  As of this morning (Friday), the 5-year normalized P/E ratio for the US is 21.4x and the 10-year normalized P/E is 20.1x.  Historically, the median 5-year P/E is 15.9x and the median 10-year is 16.4x.  At these levels, the 5-year model predicts 3.2% real total annualized returns over the next 10 years versus a historical median of 6.4%.  The 10-year model predicts 3.8%.  Either way, the return environment looks like it could remain subdued in coming years relative to historical returns.

Keeping with the US, we’re fortunate to have agencies that release massive amounts of economic and market data.  Because of data released regularly by the Federal Reserve, we’re able to calculate a Q-ratio for the US.  The Q-ratio is similar to a traditional price to book value ratio, but uses current market values for corporate net worth instead of the static values we typically find on many balance sheets.  Like the normalized P/E ratios above, we can analyze the relationship between historical values and future returns and generate a predicted value.  Currently, the Q-ratio in the US is approximately 0.89x versus a historical median of 0.75x.  At current levels, predicted ten year real annualized total returns for the US come in at 3.44%, roughly in line with the numbers generated from the normalized P/E ratios.  Of note: the statistical relationship between the Q-ratio and future 10-year returns is stronger than the relationship between P/E ratios and returns.  Take it all into account and it seems like a 3% to 4% total real return environment is a strong possibility going forward in the US versus the 6.5% return environment we’ve typically witnessed over historical 10-year periods. 

Moving to global indices, the picture looks slightly better.  The MSCI EAFE index, which covers developed markets in Europe and Asia, currently sports a 5-year normalized P/E of 16.6x.  At current levels, predicted future 10-year real total annualized returns come in at approximately 5.5%.  The MSCI Emerging Markets index currently trades at a 5-year normalized P/E of 13.8x.  Predicted 10-year returns for the emerging markets index are approximately 11%. 

With economic and earnings deterioration in Europe and parts of developed Asia over the past few years, market performance has lagged behind US markets.  Perhaps investors have “over-discounted” negative outcomes in certain corners of the ex-US developed world.  Accordingly, valuations have become more attractive on a relative basis.  The same effect is in place in emerging markets.  In essence, emerging market indices have been flat over the past three years while the economies continue to grow, albeit at a slower pace that witnessed in the past.  As such, emerging market normalized valuations have become attractive relative to US valuations.

None of the major global indices trades at levels one would consider “washed out” or extremely cheap.  Ideally, investors would be able to pick up equities at valuations in the single digits.  Nonetheless, we continue to maintain that higher valuations in the US means there’s less room for error and more of an air pocket underneath US markets should economic and corporate results not meet expectations.  For instance, US earnings expectations for 2013 remain optimistic, as we discussed briefly in our recent monthly commentary.  Analysts expect 10% earnings growth in the S&P over the next 12 months, a strong number considering margins remain near peak levels and earnings momentum has stalled for two straight quarters.  Investors in higher valued US stocks may be prone to punish earnings “misses” more so than overseas companies where hurdles are generally lower.  There’s no shortage of pessimism directed towards overseas developed and emerging stock indices and economies (especially China).  On the contrary, global investors have been hiding out in a variety of US asset classes, including equities, while Europe and parts of Asia work though various macroeconomic and political headaches.  Now, the US seems to be facing a few macroeconomic and political hurdles of its own. 

Recent returns may indicate that a shift is underway.  Since the middle of September, the S&P 500 is down 7.3% versus 5.2% for the MSCI EAFE and 3.7% for the MSCI Emerging Markets index.  Of course, it’s too early to make ironclad judgments, but this will be a trend worth watching.

Lost in the Shuffle:

This has been an incredibly eventful week in the US.  There’s obviously no need to rehash the election or the talk about the so-called “Fiscal Cliff” because they’ve been covered, and will continue to be covered, in nearly every possible venue. 

In the background, the S&P 500 in the US and the broader global indices have experienced a mini-correction since the second week of September.  Over the past two months, the S&P has declined approximately 5%; approximately one-third of the declines during the recent correction have come this week, post-election.  The MSCI World is down a similar amount.  In essence, markets have basically taken back the gains investors here and abroad picked up in the wake of major European and US monetary policy announcements.  Technically, markets were rather overbought to begin with, at least on a short-term basis, making it somewhat unsurprising that the market is letting a little air out of the tires.

Nonetheless, it’s been interesting to watch those in the media whose jobs revolve around ascribing stories to every market move breathlessly talk about the election and the Fiscal Cliff as the primary, A1 catalysts for this week’s downward action.  In reality, the election result was probably already baked into general market expectations.  Prediction markets, such as Intrade, remained firmly in the camp for the President’s reelection for months.  A number of statisticians had been forecasting the margin in the Electoral College and general national vote tally for weeks.  In nearly all cases they were proven correct, with nearly all of the statisticians coalescing around a national vote margin of 2.5% and an electoral college count for the President of 303 to 332 votes depending on which way Florida fell.  They nailed it.  In the end, I’m not convinced that markets were truly “surprised” or “disappointed” by the result.  Furthermore, pundits for weeks have sliced and diced the election and the implications for the Fiscal Cliff from every possible angle.  Nothing we’re seeing today should surprise anybody. 

On the other hand, with everything going on here, investors in the US largely ignored several overseas developments that actually may have generated a few negative surprises and contributed to market declines.  Perhaps confirming the notion that US election results were anticipated, markets in the US were relatively unperturbed after the election, with futures in the US basically flat early on Wednesday relative to the prior day’s market close; European markets were up for approximately the first half of the trading session on Wednesday.  Then, European Central Bank President Mario Draghi spoke and laid out the following statement at a conference in Germany: “Germany has so far been largely insulated from some of the difficulties elsewhere in the Euro area.  But the latest data suggest that these developments are now starting to affect the Germany economy.”  Almost immediately, futures in the US and European markets began a quick descent.   The statement seems rather innocuous, and maybe a bit obvious.  It was an important shift for markets, though.  It was the first time the ECB head had truly acknowledged publicly or officially that Germany growth was eroding and at risk.  This is important because German economic strength has been a bulwark.  Furthermore, Europeans are looking to Germany and Germany President Angela Merkel to prop up and support the rest of Europe as the continent works through a difficult economic transition period.  Alas, a look at German economic releases this week shows a wheezing economy.  Year over year industrial production declined again in September; year over year numbers have been negative three months running and five out of the past six months.  Germany’s exports went negative year over year in September, the first time this has happened since the 2008 global recession.  Services and manufacturing PMIs/surveys remain in contraction territory. 

Matters certainly weren’t helped by developments in Greece.  While many expected the Greek Parliamentary vote on a new €13.5 billion austerity package to come down to a few votes (and expected protesters to unleash their venom), investors were surprised yesterday by a statement from an EU official stating that European finance ministers weren’t ready to sign off on the release of €31.5 billion in EU funds until the “end of November.”  A positive parliamentary vote was supposed to ensure quick release of the funds.  Market declines subsequently accelerated in the US.  This is just further indication of the general confusion and mistrust that’s occurring at all levels between Greek lawmakers and European policymakers.  While I’ll go out on a limb and say that there’s a very strong chance that European ministers eventually release the bailout tranche, the damage is done.  In the face of massive electorate dissatisfaction with the austerity program in Greece, it’s been incredibly difficult to keep the current parliamentary coalition intact.  Face slaps and delays after hard decisions have been made are going to make it that much more difficult.  The delay once again required investors to discount the increased probability of a Greek default or exit and work through all scenarios surrounding these potential outcomes. 

Finally, the US isn’t the only major power working through a leadership change.  China began the process this week of transitioning the nation’s leadership at the Communist Party’s 18^th Congress.  With the controversy surrounding Bo Xilai and his wife earlier this year, protests in various parts of the country, and several major stories in the Western press outlining the corruption and capital accumulation of several important top officials, it hasn’t been a smooth year to say the least.  Observers inside and outside of China have speculated (maybe “hoped” is a better word) that the leadership would use the Congress as an opportunity to incrementally open up the political system to accommodate more voices.  Instead, President Hu Jintao delivered a 100 minute speech at the opening of the Congress that largely affirmed a status quo stance and a hard line against any major political reforms.  On the surface, this doesn’t seem like a game changer.  Investors, however, are worried about political unrest, corruption, and general economic imbalances continuing to derail China’s growth story.  Without change, investors worry the economic situation may not improve.  GDP growth this year is already forecast to decelerate to approximately 7.5% from 9.3% last year and 10.4% the year before.  China’s growth has been an important crutch for global GDP growth as developed economies muddle along.  A prolonged dent in growth rates would be problematic.  China’s equity markets are trading near the 2009 lows and thus have discounted a significant amount of negativity.  It remains to be seen whether other global markets, especially those in the US, have fully incorporated this downshift.  US multiples are elevated as we’ve discussed in the past. 

Again, it was easy to focus on the election and developments in the US this week and blame the election for volatile market moves this week.  It’s important, though, to see the forest for the trees and recognize that several significant international developments were likely more responsible for uncertainty in US and global markets this week.  Investors were reminded that there are still some thorny issues to work out abroad that could have substantial influence on US economic growth prospects in the coming year or two.  

NAIRU: An Awkward but Important Acronym!

With an election mere days away, today’s release of the non-farm payrolls number and the broader unemployment rate takes on added significance.  Understandably, most people will pay attention to the headline numbers and the overall trend.  There’s a concept, however, underlying the general employment figures both here and abroad that’s not broadly recognized or understood by the broader public.  NAIRU, the “Non-Accelerating Inflation Rate of Unemployment,” in basic terms is the level of “full employment.”  Government economists, academics, private sector economists, asset managers, and policymakers have spent a significant amount of time trying to understand true NAIRU levels in countries around the world.  Estimation of this metric is difficult, but important; the estimate of NAIRU could have serious implications, for instance, when it comes to the future path of monetary policy and could influence how policymakers approach unemployment issues in developed countries.  

Why is the estimated level of full employment important for monetary and fiscal policy authorities?  First, for monetary policy authorities at the Federal Reserve and ECB, for instance, NAIRU helps determine how much room policymakers have in terms of monetary accommodation before prices start heating up.  Labor remains the biggest cost for many companies.  In macro terms, when general unemployment is higher than NAIRU, labor cost pressures should be relatively non-existent, i.e. deflationary or disinflationary.  Simplistically, there’s an excess supply of labor.  On the contrary, general unemployment under the NAIRU rate leads to inflationary pressures.  Labor markets are deemed “tight.”  If NAIRU is estimated as being relatively high, and the gap between NAIRU and the unemployment rate is low, e.g. NAIRU falls at the 6% unemployment rate instead of the 4% unemployment rate, monetary authorities have less wiggle room to use expansionary policy. Alternately, a low NAIRU and big unemployment gap means that the authorities can (and probably should) use the big monetary guns to drive economic growth and drive labor markets back towards full employment.  When Ben Bernanke talks about using QE until labor markets improve to a satisfactory level, Bernanke and the Fed governors have NAIRU in mind.  For fiscal authorities and policymakers, understanding NAIRU is important because once an estimate is determined, it’s important to know what factors are causing a relatively high or low NAIRU so they can address the situation appropriately and create the correct policies to deal with the labor market situation.

Speaking of, what factors drive NAIRU higher or lower?  According to OECD economists, a rise in NAIRU is oftentimes tied to statistically significant increases in the ranks of the long-term unemployed, a condition we’ve witnessed in the US and many developed markets around the world.  Increases in the long-term unemployed are generally attributed to structural factors.  The OECD describes how structural factors can have an effect:

Workers who have been unemployed for some time tend to become less attractive to employers.  Not only the human capital of the unemployed diminishes over time, but also, as a result of recruitment costs, potential employees are frequently evaluated on the basis of frequency and duration of their periods of unemployment. Job search may also diminish as the unemployed lose contact with the labour market and awareness of job offers. There is indeed empirical evidence that long-term unemployed have a smaller influence on wage bargaining than the short-term unemployed (Guichard and Rusticelli, 2010, Llaudes, 2005 and Elmeskov and MacFarlan, 1993). As a result real wages do not fall sufficiently for the long-term unemployed to be “priced back” into the labour market.  Hence increases in the proportion of the long-term unemployed may push up the structural unemployment rate consistent with a stable inflation rate (i.e. the NAIRU).

Other factors, related and unrelated to the above, can influence NAIRU as well.  For instance, significant skills mismatches between the labor-force and industry (i.e. businesses across various industries demand skills that the labor force is having a hard time providing) can push NAIRU higher.  Demographic factors can affect NAIRU.  For instance, the Federal Reserve Bank of San Francisco identified that NAIRU might rise as the proportion of young workers rises as a percentage of the overall workforce.  This is salient now as the Baby Boomer generation retires en masse and younger workers begin to constitute a higher percentage of the force.

For whatever reasons, and probably because of a combination of factors listed above as well as other factors, NAIRU has risen across the developed world.  Coming back to the recent OECD research, across the OECD as a whole, NAIRU increased close to three-quarters of a percent between Q4:2007 and mid-2011.  In the US, NAIRU has increased from approximately 5.5% in 2006 to 6.1% today, based on OECD estimates.  In the UK, NAIRU has increased from approximately 5.5% in the mid-2000s to 6.8% today.  In Germany, on the other hand, NAIRU has fallen from about 8.25% in 2005 to 7.1% today.  

NAIRU: US vs Germany

Source: OECD

What are the current implications for higher NAIRUs?  In the US, it means that inflationary pressures could increase at higher levels of unemployment than we were accustomed to pre-crisis.   As of right now, there’s still a decent gap between the current unemployment rate of 7.9% and estimated NAIRU just north of 6%.  A move in unemployment towards the 6% to 6.5% level might provide an indication to the broader investing public that the Federal Reserve is prepared to move towards a more hawkish and restrictive monetary stance.  In Europe, ECB policymakers have a tricky road to navigate; employment gaps are substantial in the peripheral countries such as Spain and Greece, but narrow to nonexistent in countries such as Germany and Finland.  Hence, we’ve witnessed serious conflict in the Euro Zone over the future path of monetary policy.  Expect the bellyaching to continue.  For policymakers in general around the developed world, if we accept the OECD’s notion that higher NAIRUs are tied to higher long-term unemployed, and that high levels of long-term unemployment are tied to structural factors, then it becomes imperative to institute policies that can help bring the long-term unemployed back into the workforce.  Perhaps significant job training and similar initiatives could help.  Maybe policies shifting current unemployment benefit structures will have an effect to encourage people to reenter the workforce.  Some deeper understanding, though, of the carrots and sticks needed to get the long-term unemployed back in productive roles is required of politicians and their advisors.  Short-term lurching from problem to problem is insufficient to get these metrics moving back in the right direction.


References/Sources:

Guichard, S. and E. Rusticelli (2011), “Reassessing the NAIRUs after the Crisis”, OECD Economics Department Working Papers, No. 918, OECD Publishing. http://dx.doi.org/10.1787/5kg0kp712f6l-en

Walsh, Carl E. (1998), “The Natural Rate, NAIRU, and Monetary Policy”, FRBSF Economic Letter, 98-28, Federal Reserve Bank of San Francisco.  http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-28.html

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!