More On S&P 500 PE Ratios

As follow up to my last post regarding cost of equity and valuation multiples for the S&P 500, here is a chart showing the implied steady state PE versus the actual PE for the index since 1961.

Data & Calculation Sources: Aswath Damodaran & Michael Mauboussin

The actual multiple typically plots above the steady state estimate. This is to be expected since the market is typically assigning some value to future earnings growth, and for simplicity’s sake my steady state multiple calculation does not factor in future growth.

By calculating the steady state multiple in this way you can easily visualize how the market is valuing future growth at a point in time. When the actual multiple is far above the steady state multiple, as in the late 1990s, the market is assigning a high value to future growth. Obviously the value of future growth can swing around violently depending on investor sentiment. In fact, exploiting this tendency for the market to overvalue and undervalue future growth is the lynchpin of Ben Graham style value investing. If you buy a stock at a low steady state valuation, yet have correctly discerned there are future growth opportunities not reflected in the market price, you get a free call option on the future.

The impact of ultra-loose monetary policy shows up very clearly in this chart in 2009. The steady state multiple shoots up dramatically in 2009 as interest rates (and thus discount rates) hit historic lows. What is interesting to me about this chart is how long the actual multiple remained below the steady state multiple, almost as if the market “realized” the discount rate had been artificially manipulated and refused to play ball. Again, that speaks to the power of investor sentiment.

Superficially, it appears as though the market valuation has finally “caught up” with its steady state value and has room left to run (remember, the steady state model isn’t pricing any growth). However, as discussed in the previous post, the steady state multiple has risen due to a low discount rate. So what I think investors need to think long and hard about today is whether we are systematically mispricing risk (spoiler alert: I think we are).

That said, I don’t think investors are mispricing risk because they are stupid, or even because they are greedy. In fact, I think they are acting rationally in the face of unappealing alternatives. But that is a subject to explore in future posts.

It’s The Risk You Don’t See That Kills You

I want to share a chart I believe is of paramount importance to asset allocation and valuation in today’s environment. It graphs the implied cost of equity for the S&P 500 alongside the steady state earnings multiple that number implies. The underlying data is from NYU Professor Aswath Damodaran and the steady state calculation is taken from a paper by Credit Suisse’s Michael Mauboussin.

Professor Damodaran estimates the implied cost of equity for the market by solving for the discount rate that sets the present value of projected S&P 500 dividends equal to the current level of the index. There are plenty of quibbles you can raise with this simple model (as with all models it is a dramatic oversimplification of messy reality). However, I don’t believe quibbles diminish the key insight.

Namely: the implied valuation of the equity market moves inversely to its implied cost of equity. This should make intuitive sense to anyone who has ever discounted a cash flow. If you were wondering, the calculated correlation is around -.90.

Here is my chart:

Data & Calculation Sources: Professor Aswath Damodaran & Michael Mauboussin

What this chart makes abundantly clear is that over the past thirty years the justified steady state multiple for the S&P 500 has crept steadily upward. Not so much because the risk premium has contracted but because the T-Bond rate (used as proxy for the riskfree rate of interest) has come down dramatically.

Now, that is a fairly superficial observation. Why does it matter?

Reason #1: A popular contrarian narrative in the markets is that central bankers have artificially suppressed interest rates, and that absent their interventions the “natural” rate of interest would be higher (implying a higher discount rate and thus lower sustainable valuation multiples). The key risk to this thesis is that low rates are not some exogenous happening imposed on the market by a bunch of cognac swilling technocrats, but rather a consequence of secular shifts in the global supply and demand for funds. Specifically, that these days there is a whole boatload of money out there that needs to be invested to fund future liabilities and too few attractive investment opportunities to absorb it all.

If low rates are actually a function of the supply and demand for funds, it doesn’t ultimately matter what central bankers intend do with monetary policy. Market forces will keep rates low and elevated valuations will remain justified.

Reason #2: Capital is allocated based on the opportunity set across asset classes. A 5% implied IRR on the S&P 500 may suck wind relative to “normalized” risk, but it is better than what you can expect in bonds. As long as equity looks like “the least bad alternative” valuations will remain elevated. If you are trying to short the market into this dynamic you are going to have a brutal go of it unless you are extremely fortunate in your timing. This is precisely why so many bearish investors have been wheeled out of the market on gurneys over the past 5 years.

Reason #3: By way of anecdotal evidence, sentiment is getting more and more bullish. Every day I am reading articles about the possibility of a market “melt-up.” If the market melts up it may narrow the implied risk premium and further reduce the implied discount rate. If this occurs, it leaves investors even more exposed to a double whammy: simultaneous spikes in both the riskfree interest rate and the risk premium. The years 1961 to 1980 on the chart give you an idea of how destructive a sustained increase in the discount rate can be to equity valuations.

My overall assessment of today’s markets is that perceived risk is low across the board. As a result investors are not generally being well-compensated for the real risks embedded in their portfolios.

Some Acknowledgements

This post is a synthesis of many arguments I have read over months and years. I therefore want to credit Josh Brown, John Hempton, Philosophical Economics, David Merkel and GMO for their tremendously insightful comments and analyses, which have helped me get to grips with the “real world” supply and demand fundamentals underlying today’s market valuations.

4Q17 Factor Performance

A while ago I created some charts to track factor performance in the US equity market. The data is from Ken French’s Data Library. As you might expect, it is the Fama French Five Factor data, as well as data for the North American Momentum Factor.

From an analytical point of view I always find it helpful to dis-aggregate investment returns, as this can offer a more nuanced picture of the fundamental drivers of equity market returns.

Source: Ken French’s Data

Our first factor is Market. Looking at this chart it’s no wonder there has been a bull market in passive investing lately. Since May of 2014 simply being in the market has return a cumulative 45%. Getting market exposure as cheaply as possible has proven to be a great strategy over this time period.

Source: Ken French’s Data

Next up is size. As a whole small companies have not generated much of a return premium in recent years.

Source: Ken French’s Data

Value is a much beloved and storied factor and if you follow markets at all you have probably read plenty of material calling value investing into question lately.

Source: Ken French’s Data

Momentum has taken investors on a wild ride in recent years. 2015 in particular was an exceptional year for momentum, driven in large part by internet technology and biotechnology stocks. Despite a vicious drawdown in late 2015 and early 2016 momentum is surging again on the back of bullish sentiment.

Source: Ken French’s Data

Nothing to write home about in terms of operating profitability.

Source: Ken French’s Data

Investment is more or less the mirror image of the momentum chart. The investment factor is a bit counter intuitive in that it is measuring the premium associated with a conservative corporate investment policy. There have been a couple of inflection points in this chart and more recently investors seem to again prefer companies investing more aggressively in growth opportunities.

Finally, here is my updated chart of rolling factor returns back to 2000:

Source: Ken French’s Data

Observations & Implications

The most significant takeaway from this data is that since the financial crisis, the best performing factor has been Market by a wide margin. I don’t believe it is an accident that strong Market factor performance coincides with both the trend toward passive investing and the extraordinarily low interest rate environment we have seen since the financial crisis. I suspect there is some degree of feedback loop in play here: low interest rates push up equity valuations which enhances broad market returns which is a tailwind for low-cost, market cap weighted equity funds (a.k.a index funds).

Furthermore, since the financial crisis several factors have shown muted performance versus their pre-crisis averages, notably Size and Value. This is a headwind for active mutual fund managers. Most of these managers run diversified portfolios where the factor exposures drive the majority of the variation in their returns. If they are good (or lucky) they will add some incremental return through security selection. Many managers also intentionally tilt their portfolios toward small stocks and value stocks. They have not been rewarded for these tilts in recent years.

The trillion dollar question here is whether Market factor dominance is a secular or cyclical trend. I am inclined to believe it is cyclical, albeit with a significant caveat.

My significant caveat is that Market factor dominance will last at least as long as global interest rates remain low. In this low rate environment the notion that There Is No Alternative forces capital that would otherwise be content to earn 5% annually in long-dated Treasury bonds into risk assets, pushing up valuations indiscriminately. Until investors with lower risk preferences determine they have viable investment alternatives, equity valuations will remain elevated across the board and the Market factor will perform well.

Sentiment seems quite bullish so far in 2018. This has animated the spirits of a number of investment managers. Yet here is the YTD data for the Treasury yield curve. The market is absolutely not pricing for significantly higher economic growth, inflation or interest rates over the very long term (20-30 years). I am not sure there is any actionable insight in this but it is a troubling disconnect.



Return Free Risk: A Picture Book

Once upon a time there was an asset class called high yield debt. It consisted of all the lowest quality bonds issued by all the lowest quality companies. Companies like Frontier Communications and Sprint and Valeant Pharmaceuticals.

And yet, because There Is No Alternative but to buy risk assets these days, particularly for Yield-Starved Fixed Income Investors, in aggregate this debt traded at yields well below the historical average.




You see, what the Yield Starved Fixed Income Investors had forgotten was that high yield debt returns are (badly) negatively skewed.




And so what the Yield Starved Fixed Income Investors had bought was return free risk.





(Charts from a presentation by Troob Capital Management)