Good Economy, Poor Returns and the correlation; Lessons from our Economists
Economics and the markets
Good economy, poor returns?
EVER since the Federal Reserve started to talk of tapering, the equity market had had a fairly cautious attitude towards economic data. On some days, bad economic news has been good for the market on the grounds that the Fed would be less likely to taper; good news has occasionally provoked a sell-off. Overall, the trend has been upwards, as illustrated by the Dow's ability to top 16,000. Indeed, we could almost say we are back in Goldilocks territory, where the economy is not so strong (as to cause inflation and monetary tightening) or so weak (as to cause recession and a collapse in profits) but "just right".
It seems common-sensical to say that a strong economy should be good news for equities, since profits are linked to GDP, and a weak economy should be bad for the stockmarket (think of the 1930s). But history suggests there is very little correlation between GDP growth and equity returns over the long run (see this paper from Jay Ritter, for example). One reason is that the stockmarket is not an exact representation of the domestic economy (some sectors are in government, or family-run hands; the biggest companies are multinational). And a second reason, oft forgotten, is that the key driver of returns is the starting valuation.
This point is explored in a recent Financial Analysts Journal paper by William Bernstein (you need to be a CFA to read it, or pay a fee) called "The Paradox of Wealth". Mr Bernstein asserts that
in the very long run, an increase in societal wealth and well-being carries a paradoxical cost, namely, a reduction in the expected return on both risky and riskless assets
The Gordon growth model, which this post has emphasised in the past, suggests that equity returns are equal to the dividend yield plus dividend growth, plus or minus any change in the rating. When an economy grows fast, compnaies are raising capital to fund that expansion; existing shareholders find themselves diluted by this new issuance. Mr Bernstein writes that
The empirical data suggest that rapid economic growth results in an even faster rise in the number of shares than in aggregate earnings and dividends, and so it actually decreases g (dividend growth) and thus—with a constant dividend payout—returns as well.
In the fast-growing Asian nations, this dilution factor may be almost a third of dividend growth. Mr Berstein adds that
Perhaps the greatest period of technological advance in human history occurred during the second quarter of the 19th century, when the steam engine and steam locomotive increased the speed of transport and the telegraph increased the speed of communication by one and three orders of magnitude, respectively. Extremely fragmentary data suggest that security returns were also less than spectacular in that earlier era
Another way of looking at the issue is that primtive societies have very high interest rates because of the risks involved. As societies develop, the risks fall (properrty rights are established, risk-sharing vehicles are created etc) and rates fall. Low rates encourage more businessmen to borrow, and boost capital growth in a virtuous circle. But the corollary is that the returns to the owners of capital decline.
The effect is disguised in the short term by the effect of yields on capital values; a fall in the dividend yield from 4% to 2% doubles share prices (other things being equal). But this effect is likely to come to an end eventually.* Part of the reason why equity returns were so strong in the second half of the 20th century was a boost from the valuation effect. But that stopped in 2000.
So how are current valuations? Your blogger is a firm believer in the Shiller p/e and the Q ratio, both of which show the market to be pretty overvalued (if not at dotcom bubble levels). An alternative approach comes from GMO which in its latest report finds that
fair value for the S&P 500 is 1100 (as opposed to its level of around 1800) and the expected return is -1.3% per year for the next seven years after inflation
This is based on the market returning to normal valuation levels (in terms of price-to-book, returns on sales etc) over a seven-year period. Could GMO be wrong? Ben Inker of GMO writes that
The pleasant way we could be wrong is if the U.S. is about to embark on a golden age of corporate investment and economic growth that will gradually compete down the current return on capital such that overall profits manage to grow decently as the P/E of the stock market wafts slowly down. This would solve lots of problems, including the federal deficit and unemployment and, quite possibly, health care costs as well, but there is sadly no evidencewhatsoever that it is occurring
As noted before, business investment has been disappointing despite low rates, in part because companies have used their spare cash to buy back shares.
Returning markets to a "normal" valuation implicitly assumes that returns will be normal going forward, at 5.7% real. But perhaps the market is reasonably valued on the basis that future returns will be permanently lower. The problem with the latter outcome is that investors aren't making that assumption.
every pension fund, foundation, and endowment – not to mention every individual saving for retirement – would be in dire straits, as every investors’ portfolio return assumptions build in far more return. Over the standard course of a 40-year working life, a savings rate that is currently assumed to lead to an accumulation of 10 times final salary would wind up 40% short of that goal if today’s valuations are the new equilibrium. Every endowment and foundation will find itself wasting away instead of maintaining itself for future generations. And the plight of public pension funds is probably not even worth calculating, as we would simply find ourselves in a world where retirement as we now know it is fundamentally unaffordable, however we pretend we may have funded it so far.
None of this means that market will fall tomorrow, or next month. But there is a paradox at the heart of this bull run - investors are paying high valuations and expecting high returns, and they can't have both.
* Yes, I know mathematically that yields can fall from 2% to 1%, from 1% to 0.5% and so on. But this Zeno's paradox line of reasoning must have a practical limit.