What’s Eating Equities?

19 Jan 2016

In the normal course of things, this column would focus on an aspect of the fixed income market that is of current interest. But given that we are at the start of a new year, and that equity markets have sold off sharply, I think it is appropriate to reflect first on equity markets and to then pivot back to fixed income, as both markets are interlinked: investors can choose to allocate their capital to one or the other, and will use their expectations of risk and return to guide their asset allocation decisions.

The forward returns of bonds are well approximated by their yield to worst minus their expected loss. Equities, though, are a different kettle of fish: their expected return depends on a number of factors, including future earnings growth and their current valuation in relation to earnings and book values. In recent years, Professor Robert Shiller’s CAPE ratio (an acronym for Cyclically Adjusted P/E) has gained wide acceptance as a measure of market valuation on account of the fact that it is a good predictor of long horizon equity returns. Currently, CAPE has a value of 26, which is much higher than its historical average of 16.67, and suggests that stocks are overvalued.

But this is far too simplistic of an argument. In a recent paper1, Cenk Ural of Barclays and I show that there is a linear relationship between the reciprocal of CAPE and expected returns, and use a variety of enhancements to the basic CAPE methodology to show that the current expected return of the S&P 500 is about 6%. This is lower than it has been historically (see “Chart of the Week”), but by way of comparison, the yield to worst of the Barclays U.S. Aggregate Index is 2.42%, while that of the U.S. Corporate Index is 3.6%.

Seen in this light, stocks do not look rich, even though they indisputably look rich by historical standards. The primary risks to stock prices, in our view, are a decline in the trend rate of earnings growth – a 1% decline in GDP growth will result in a 60 basis point reduction in the expected return of equities – and a decline in profit margins from their currently elevated level of 10% of revenues to their historical average of about 6%, which will force equity prices down by a third.

Both risks are real: the decline in the labor participation rate coupled with a stagnant productivity growth will likely translate to weaker economic growth, which in turn will lead to weaker earnings growth, and a decline in labor market slack will lead to increases in wages that are not easily passed through to customers, resulting in a decline in profitability. However, the labour-capital income split has been the subject of numerous studies over the past decade, and shows no sign of concrete resolution. In any event, even if both risks are realized, the realized return on stocks over the next decade will only be slightly lower than that of bonds, making them reasonably attractive in a strategic asset allocation framework.

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