Thursday, March 27, 2014

Valuing The Bull Market

  • PE measures suggests the market is overvalued.
  • ERP measures suggest that it is undervalued.
  • A lot depends on the outlook for bond yields.

Earlier this month, the Post-Crash Bull Market turned five years old, which some people think is close to its expected life span. Everyone has an opinion about whether it is now time to sell or to hang in there. As readers know, I am in the latter camp.

Serious investors need a sophisticated understanding of the tools available to judge whether the stock market is over or under valued. Such a judgement is highly actionable from an investment perspective, unless you still believe in the EMH and the tooth fairy. You can’t look at the market over the past decade and say that market-timing doesn’t matter. If you bought in 2007 and sold in 2009, it mattered. If you bought in 2009 and have held on, it mattered. The market is volatile and inefficient.

Given just how highly actionable market valuation tools are, you would expect Wall Street to be falling all over itself to publish research and data on the subject. But, because the data is so valuable, they don’t. 

The Street is very close-mouthed on this subject. The ignorant blather on TV about the stock market never goes near a discussion of valuation techniques. To get the data you need to calculate it yourself (no thanks!) or go to academia. There are two schools in academia in this discipline:

The PE School: Bearish
One school believes that equities can be valued without reference to bond yields, or argues that the Fed has used QE to artificially depress bond yields below their natural level. This view has particular appeal to those who believe that QE has artificially held down bond yields since the crash. This school, let’s call it the PE school, makes adjustments to the  reported PE ratio in order to smooth out earnings and inflation noise. For example, Prof. Robert Shiller at Yale calculates a cyclically-adjusted PE ratio, which uses averaged earnings and constant dollars to calculate the CAPE. Shiller’s index indicates that the market is substantially overvalued in a historical context. The current CAPE is 25.5%, versus an historical mean of 16%. That means sell, unless you are very bullish about earnings growth--which I am not.

The ERP School: Bullish
Another school believes that equity yields, meaning the reciprocal of the PE ratio (the EPR), should be be compared with  the risk-free rate (RFR). This makes sense to me because, historically, the EPR has been correlated with interest rates: when interest rates are high, so is the EPR: the higher the bond yield, the higher the premium demanded by investors to hold stocks. There is therefore a need to abstract from the level of interest rates in order to measure the equity yield. Hence, this school looks to the equity risk premium (ERP) as a measure of  the yield premium offered by stocks over the RFR. This school, which I will call the ERP school, seeks to adjust the earnings yield to reflect the level of long-term interest rates. This can be done in two different ways: (1) by subtracting the RFR from the EPR which leaves the ERP; or by dividing the ERP by the RFR, the ERP/RFR ratio. (We could also divide the EPR by the RFR, but no one does that.) Intuitively, both measures look useful to me. I want to know how big is the premium that I am being paid to own stocks, and I want to know how big the premium is in relation to the RFR. Luckily, both measures are calculated and published by Prof. Aswath Damodaran at NYU.

Damodaran calculates the ERP from 1961 until now. The historical range has been from 2.7% in 1972 to 6.5% in 2009. The median is 4.0%. As of March 1st, Damodaran calculated the ERP at 5%, which is 25% above its historical median, and is comparable to the elevated levels of the 1970s, when inflation was out of control and bond yields were in the double-digits. This measure suggests that today’s S&P is very undervalued, unless you think that bond yields are artificially depressed and/or are likely to go much higher--which I don’t believe.

Damodaran also calculates the ratio of the ERP to the RFR for the period 1961 until 2013. Over this period the minimum observation was .32% in 1999, and the maximum was 3.3% in 2012. However, the data stayed within a narrow range for 30 years, from 1962 until 2001, when the median was around .5%, and the range was .4% to .9%. Then something happened in 2002: the ERP started to climb out of its historical range to a level of 1.1% between 2002 and 2007. Since the crash, the ERP has been literally off the charts, reaching an all-time high of 3.2% in 2011 and 2012. Since then it has declined to the region of 1.6-1.8%, far below its post-crash high, but far above its historical range and median. Using this ratio alone, it appears that the market is still very undervalued. If this ratio were to return to its pre-crash levels, the market would be twice what it is today, ceteris paribus. That makes today’s stock market an historical investment opportunity--unless you believe that the price of Treasuries has been artificially inflated by the Fed, which I don’t.

Bond Yields Are Not Artificially Depressed
A word on bond prices and yields. I don’t think that bond yields have been artificially depressed by QE, or at least not by much. Bond yields have been depressed by very subdued inflation expectations (which logically should have risen due to the Fed’s “massive monetary stimulus”). The Cleveland Fed calculates an estimate of the market’s 10-year expected rate of inflation. Despite the Fed’s massive monetary stimulus, expected inflation has declined over the past five years, from above 2% to below 2%. This might be because inflation under QE has been considerable lower than it was pre-crash. Before the crash, core inflation was consistently above the Fed’s 2% target; since the crash, it has been consistently below the 2% target, and has lately been bouncing around 1.1%, which is about half of its precrash level. Therefore, the reason bond yields are low is not because of QE, it is because of declining inflation and declining inflation expectations. There is nothing artificial about today’s 2.8% yield. And I would add that today’s yield is much higher than it was in mid-2012. The bond selloff has already happened--and is baked into the current ERP.

The age of the bull market and the level of the S&P are meaningless data. The market must be objectively valued. By one measure it is overvalued, while by another it is undervalued. I find the latter measure to be more congenial intellectually, and also more predictive historically. Hopefully some smart Ph.D. candidate will someday run the regressions and tell us which is the most predictive valuation measure.

EMH: The efficient market hypothesis, which holds that the stock market efficiently incorporates all of the knowable data and is the best estimate of future market value.
QE: Quantitative easing, the Fed’s policy of buying Treasury bonds.
PE: The ratio of the price of an equity or equity index to annual earnings.
CAPE: Robert Shiller’s cyclically-adjusted PE ratio.
EPR: The ratio of earnings over price, the reciprocal of the PE ratio, also known as the earnings yield.
RFR: The risk-free rate, a proxy for which is the 10-year Treasury bond yield.
ERP: The equity risk premium, which is the EPR minus the RFR; in other words, the premium of stock yields over bond yields. (Think of it this way: the inverse of the RFR is the bond market’s PE, which today is 36x).

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