A Collision of Sentiment & Value
It was the triumph of hope over despair. Equities reigned supreme in the year of the Pandemic. The vaccine arrival delivers relief for the despondent economy, in particular the leisure and hospitality sectors. In contrast, unemployment is at levels not seen in generations, and investors salivate as equity valuations reach multi-decade highs. At the same time, government debt and deficits achieve levels unseen for seventy years. The confluence of Millennial investors focusing on familiar companies with unprecedented monetary stimulus drives the divergence between equities and the economy. Valuation levels suggest the continued primacy of equities is doubtful, particularly for US technology. The quandary is that valuation gaps can endure for years. With dividend yields above government bond yields, cash flow investors face a parallel dilemma. The primacy of sentiment makes it a year of tactical investing. Timing is everything.
All asset classes come with risk this year. Value will emerge by managing these risks.
A price for everything. Euphoria and fear sometimes overcome markets and places their current value in doubt. This year was no different. The fear of a global pandemic sent the markets tumbling in March as fear embraced investors. Prompt fiscal and monetary actions vanquished the fear. Euphoria now reigns as the price of the broad equity markets and some sectors exceed their pre-pandemic levels. With earnings still below their prior peaks and the economy about five percent below apex, the battle is between price and value.
Markets have long provided buyers and sellers a place to decide on a price to exchange an item. A mutually agreed price suggests a fair price for that moment. Whether the price reflects the future value is another question. This relationship is particularly relevant in the financial markets, where income streams are projected decades into an uncertain future. The cyclically adjusted price-to-earnings (CAPE) ratio is a well-known measure of equity valuation, capturing the relationship between prices and earnings. The current high valuation tends to bode poorly for future returns, but only time will tell whether the price is too high.
Exhibit 1. Cyclically Adjusted Price/Earnings Ratio
Source: Robert Shiller. Ratio is price to the average 10-years trailing real earnings.
Value is in the eye of the beholder. There are as many ways to measure value as there is to cut a cake. While the way the cake is divided does not change the size of the cake, the way value is measured can change the perceived value. Modest changes to the assumptions underlying the model can change the perceived value, even though the base data is the same. Indeed, an altered decision can occur from a different framing of the question.
The CAPE model measures current equity prices relative to the trailing ten-year real earnings. Missing from the valuation are competing assets that an investor may choose. The model is arguably incomplete without a comparable risk-free investment. The model is adjusted to account for Treasury bonds' real interest rate level to account for this deficiency. This small adjustment yields a significantly different value perception with equities expected to earn about five percent more than Treasury bonds in real terms (exhibit 2). While this number is roughly consistent with the long-term average, the range of outcomes is quite wide. Similar data, different conclusion. This outcome emphasizes that measuring future value is a nebulous affair where the frame of reference can alter the conclusion.
Exhibit 2. Excess Earnings Yield
Source: Robert Shiller, CRM calculations. Excess earnings yield is the real equity return above the real 10-year Treasury bond yield. This measure is analogous to the equity risk premium.
Aim big, miss small. A way to overcome the sensitivity of a measure is to assess another object that is less sensitive to the framing. Ideally, the market is highly liquid, large, and has a valuation measure linked to the market. The Treasury bond market is such a market and is one of the world's largest and most liquid markets. The uncertainty comes to the value measure. Fortunately, it is less sensitive to framing than equity markets.
Treasury bonds reflect the full faith and creditworthiness of the United States. Through their elected government and their tax policy, the people have a full call on the assets of the country. In essence, a bond is a debt issuance on the country’s future growth, which is the fully diversified portfolio and is the risk-free (correctly minimized risk) investment. The implication is that deviations of Treasury bond yields from the economy’s nominal growth rate indicate valuation gaps. By this measure, real Treasury bond yields are at levels not seen in 60-years, when a multi-decade bear market for Treasury bonds began (exhibit 3). The measurement error comes from whether prior inflation is indicative of future inflation.
Exhibit 3. Real 10-year Treasury Yield
Source: Federal Reserve Database. CRM calculations. Current bond yield minus the trailing 10-year inflation rate.
A relative reality. The error term for the measure of future inflation hinges on whether inflation is a monetary phenomenon. The Federal Reserve adopted a numerical inflation target of two percent and will do whatever is possible to achieve this outcome through its monetary tools. Even though realized inflation for the past decade is under this level, it may increase in the future. The implication is that this current valuation measure of Treasury bond yields may understate the level. Regardless of the future direction of inflation, investors are most likely to receive nothing or less on their Treasury bond investment in real terms.
One equity measure shows low expected returns, while another displays average excess returns. The reconciliation is straightforward. Since the real interest rate is lower, so is the equity return. The average ten-year real return for equities over the last seventy years is about 6.8% (exhibit 4). The corresponding excess equity return is 4.7%, slightly above the current reading of 4.3%. Thus, a high valuation for equities merely reflects the outcome that all returns are expected lower than the average. If the low real yields on Treasury bonds continue and the equity valuation correct, it still will result in expected total real equity returns of merely three percent. It is the best of a scant litter.
Exhibit 4. Real 10-Year Total Return of the S&P 500 Index
Source: S&P CapitalIQ, Robert Shiller, CRM Calculations.
An echo of the past. While valuations may give the investor pause, the future may exceed these paltry expectations. A hallmark of higher productivity in the US economy is the proportion of the prime work-age people (e.g., 35-50 years old). This group has two beneficial characteristics for equities: a higher level of productivity versus their peers and a higher propensity to invest for the future. When this cohort is in the ascendance, they lift company earnings through high productivity and increase equity prices by higher demand. This group will continue to grow in the workforce for the next decade (exhibit 5) and should support equities for the period with their ascendance.
Exhibit 5. Productivity Gap
Source: S&P Indices. 10-year total return. United Nations, Department of Economic and Social Affairs, Population Division (2015). CRM calculations. The workforce is prime age between 19-65 years. The Learners are ages 20-34, the Producers are ages 35-49, and the Managers are ages 50-64. The gap is the Learners minus the Producers as a percent of the workforce.
While there are few guarantees for investing, demographics are inevitable. As investors clamor for the next game-changing technology, the people’s mundane reality of progressing in a service based-economy lumbers forward. This action supports the thesis that equities can continue their run for quite a while, whether driven by sentiment or fundamentals. In contrast, Treasuries or other bonds offer a meager outlook. Risk should have a reward.
The excerpt is the Macro View section of Capital Risk's Global Portfolio Strategy for the fourth quarter of 2020.