Does the Market Have a Political Preference?



Does the stock market favor one political party over another? One might assume the performance would be roughly in line over a long period of time under both Democratic and Republican administrations.  Surprisingly, history tells a different story. Going all the way back to 1932 with the election of Franklin D Roosevelt, there have been 7 Democratic and 7 Republican administrations.  This encompasses a period of time that includes the recovery from the Great Depression, World War II, an oil embargo, the Dot-Com Bomb, the Global Financial Crisis, and of course, most recently, a global pandemic.  In short, there have been plenty of economic disruptions or crises with both parties at the helm of government.   A commonly-held belief is that Republicans are the party of fiscal responsibility, lower taxes, increased job prospects, and lower deficits while Democrats focus on the expansion of social welfare programs that carry a higher price tag, resulting in higher taxes and/or deficits. Do these conventions hold up?

According to the data, over the last 9 decades, the Republicans have lagged their counterparts in terms of economic growth (as measured by GDP and job growth) and stock market returns.  Below is a chart of annualized GDP (Gross Domestic Product) growth by administration.

 

One need not be a statistician to see the stark contrast.  According to Blinder and Watson[1], “The US economy has performed better when the president of the United States is a Democrat rather than a Republican, almost regardless of how one measures performance.” 

Another way to view this is just looking at the headline numbers:



Now, let us take a look at how markets have performed under both Republican and Democratic administrations:

 

Again the data suggests that, historically, the stock market has performed better during Democratic administrations. 

Obviously, this does not prove cause and effect, nor does it show that there is a linear relationship.  The timing and severity of the crises outlined above has had a significant impact on the steepness and duration of market drawdowns.
 
This data does, however, complicate the argument about fiscal austerity versus stimulus.  As the Biden administration contemplates a $1.9 trillion recovery package, concerns about the debt level alone may be overblown if we are to look at history as a guide.  


[1] Blinder, A.S. and Watson, M.W., 2016, Presidents and the US Economy: An Econometric Exploration, American Economic Review, 106(4)

Is Value Dead?

Given recent performance, some clients have raised the question about whether the value premium is “dead.”  As evidenced-based investors, we typically turn to the data to demonstrate and reinforce that value is one of the single most important factors in investing.  In fact, next to the equity premium itself (the stock market minus one-month Treasury bills), the value premium is, perhaps, the most persistent and significant.  From an economic perspective, if you believe and expect that there are differences in expected returns across stocks, one can easily extrapolate that there is a value premium.  This means that stocks with high discount rates are expressed as lower prices, which in turn, means that lower priced stocks tilt toward higher expected returns.  However, the value premia are highly volatile and can appear quite suddenly.  This means if you are not invested in these stocks, you will miss that momentum change and the corresponding upward movement of these stocks. 

You certainly would not have been faulted for dialing back on value over the past decade as it has been in somewhat of a bear market, especially when compared to growth stocks.  In the chart below, you can see how value has performed over a very long time horizon.  No asset class performs in a linear fashion as is evident in the graph.  However, a preponderance of years dating back to 1937 in the US, show the value premium has been accretive to those that had this exposure in their portfolios.

According to a recent communication from Bank of America, there are “several reasons” why investors believe there will be a comeback in value, including:

  • In 14 of the last 14 recessions, value stocks led in the recovery, and economists believe that we are nearing the GDP growth trough
  • Profits drive style cycles, and profits forecast indicates trough growth in Q2 2020. In every profits recovery except two (post-Tech Bubble and 2016), the trough to peak in corporate profits growth saw value lead by a large margin
  • Value is currently deeply neglected
  • Value stocks trade at record levels of cheapness relative to momentum stocks; furthermore, growth factors trade at a record premium to the market on almost any measure

Finally, the top stocks in the market, FAAMA (Facebook, Amazon, Apple, Microsoft and Alphabet) account for roughly 40% and 20% of the NASDAQ and S&P 500 respectively.  These are unsustainable valuations and will likely lead to lower expected returns of these growth stocks over time.  Therefore, value may well be about to see the light of day…again.

Will The Rally In Cheap Markets Continue?

 
Stock markets around the world have appreciated significantly from their late March lows but the rebound has not been even. Since the lows, US equity markets have rebounded more than most developed market countries during Q2 2020, but continue to trade at much higher valuations that other markets.

Current Global Stock Market Valuations
 
 US Markets[1]Non-US Markets[2]Emerging Markets[3]
Price/Earnings23.4918.9413.28
Price/Book2.991.391.34
Price/Sales2.171.071.08
Price/Cash Flow11.766.234.82
 
Source: Morningstar
[1] SPDR S& P500 ETF Fund (SPY) as of July 10th, 2020
[2] iShares EAFA Index Fund (EFA) as of July 7th, 2020
[3] Vanguard FTSE Emerging Market ETF (VWO) as of May 31st, 2020

This is important because there is a strong long-term correlation between current equity valuations and future expected returns.
 
Correlation of CAPE Ratio with S&P 500 Index Real Return

 
Source: Research Affiliates, LLC, based on data from the Robert Shiller database. 1881 – October 2017
 
CAPE: Also known as the Shiller P/E, the Cyclically Adjusted Price to Earnings Ratio (CAPE) is a measure of price divided by an average of 10-year earnings, all adjusted for inflation. The objective of the CAPE is to provide a measure of price to earnings that is independent of short-term fluctuations in the business cycle.
 
During a recent interview with one of the Co-Founders and Managing Partners of our sister firm MASECO Private Wealth in London, Nobel Laureate Robert Shiller reiterated how non-US markets appear to be inexpensive with higher expected returns. Click here for the full interview. 
 
On a relative basis, non-US markets are also trading at inexpensive valuations compared to their own historical valuations. Emerging Market equities are cheaper than 88% of history and non-US Developed Market equities are cheaper than 77% of history while the US is only cheaper than 5% of history.[4]  
Current and Historical Market Valuations.[5] 
 
 
Source: Research Affiliates, June 30th 2020

As you might recall from our recent article on valuations released in April, the long term valuation differences between regions has led to our relative overweight of Emerging Markets versus US stocks. This decision has started to pay off for investors and recently Emerging Market equities have outperformed US equities. In the past month, Emerging Market equities have outperformed the US and non-US Developed Market equities by circa 10% respectively.

Emerging Markets Outperformed US and Non-US Developed Markets in the Past Month [6] 
 
 
Source: Morningstar, June 8th to July 8th 2020

To summarize, investors need to decide where to take risk in their pursuit of returns. In equities, we currently favour International and Emerging Markets over the US because of their inexpensive valuations in both absolute and relative terms and because there is a high correlation between current valuations and future expected returns.
 
 
 

[4] Based on CAPE valuation as of May 31st, 2020 source: Research Affiliates
 
[5]
 
[6] SPDR S&P 500 ETF Fund (SPY), iShares EAFA Index Fund (EFA) & Vanguard FTSE Emerging Market ETF (VWO)
 
 
 
Accessing Your Accounts

If you wish to find out the current value of your investment portfolio, you can do so the following ways:
  • log on to the client portal provided by your platform provider; or
  • contact your Wealth Manager.

Main Street vs. Wall Street

Main Street and Wall Street seem to have decoupled in the last few weeks. It appears that investors are ignoring any future negative financial impact of the COVID-19 pandemic. They seem to expect global economies and corporate profits to return  to lastear’s level (V-shaped recovery) and that a vaccine will be found before a new wave of infection hits. However, most of the recent economic data released paints a different picture , for example, unemployment is still at very high levels.

Risky assets had a rapid recovery
Returns of global equities and investment grade bonds are now positive for the first time since the start of March 2020 and high yield and emerging market debt have recovered much of their losses.

Source: Morningstar, own calculations, data as at 22nd June 2020

From a behavioral angle, hope and greed have overcome fear. The most commonly quoted fear gauge, the VIX, has receded significantly from its March high:

Source: Yahoo.com, data as at 22 June 2020

Many people still suffer
Many people have lost their jobs over the course of the pandemic and its rapid spread across the world. In the US, unemployment has increased to record levels:

Source: US Bureau Labor of Statistics, data as at 01 May 2020

Some leading US economic indicators like The Purchasing Managers’ Index (PMI) have bounced back from recent lows, but a turn in US corporate profits has not yet been reported:

Source: U.S. Bureau of Economic Analysis, National income: Corporate profits before tax (without IVA and CCAdj), retrieved from Federal Reserve Bank of St. Louis, data as at 01 January 2020

For 2020 the Fed projects that US real GDP will shrink by 7.6% to -5.5%. Two months ago, the IMF urged governments tto provide further economic stimulus to avoid a steeper recession; both the European and US governments are in discussions to do just that.

Wall of Money
In March, the Fed went beyond decreasing interest rates and started buying assets on an unprecedented scale and scope. The Fed has continued to take significant actions. Only this month it announced that it is expanding its asset purchase program from buying exchange-traded funds of investment-grade bonds to purchasing individual bonds. Consequently, the below chart shows that its balance sheet has almost doubled to over $7tn.

Source: Federal Reserve Bank of St. Louis, data as at 17 June 2020

Equally remarkable, growth in U.S. M2, a broad measure of money supply, has been its strongest since the Federal Reserve’s records began in 1960. Such huge liquidity is trying to find good investments, and part of it supported the recent stock market rallies.

Source: Federal Reserve Bank of St. Louis, data as at 01 May 2020

Mr. Market: An expert in assessing the future
Mr. Market was introduced by Benjamin Graham in his book “The Intelligent Investor” published in 1949. Graham is often referred to as the “father of value investing” and was the teacher of Warren Buffet at Columbia University.

Mr. Market is always a step ahead of the economy, as he prices in future economic developments. Therefore, he reacts positively to news on government stimulus, low interest rates and other central bank actions, as well as progress on developing a vaccine against the COVID-19 virus, because all of these are positive for economies and future corporate profits. Therefore, it is fair to expect economic developments to become positive in the not too distant future. The big questions such as “when?” and “by how much?” may have different answers from what Mr. Market currently prices in, as Mr. Market cannot assess known unknowns. , equally, nor can anyone else. Mr. Market is also influenced by broad investor opinion and sentiment, as well as excess liquidity.

However, doubting whether Mr. Market is right and betting against him takes exceptional skill and expertise to successfully assess vast amounts of data. Many famous investment voices from Graham to Buffet, Bogle to Fama advise investors against trying to time the market, just as we advised our clients only three months ago not to give in to fear and sell equities. We now caution them not to follow feelings of “missing out” and buy into the recent rally, proactively increasing equity exposure. Instead, following Mr. Market within your current strategy should be the better approach, versus hoping to be lucky. This article is authored by Helge Kostka,
Chief Investment Officer of MASECO Private Wealth, and Investment Committee member for MASECO Asia.

Will the rally in cheap markets continue?

 

Globally, stock indices are on the up again after a slight jitter in June. We are questioning how synchronised this move is, monitoring the effects of our regional equity allocations daily. As you might recall from our article on valuations released in April long term valuation differences, the main driver behind our relative overweight of emerging markets versus US stocks, were very high at the end of March.

Early signs that neglected cheap markets are attracting investors’ attention
Today we look at our main regional split, comparing cumulative returns in USD between Global stocks as well as US, International and EM equity over the last 2 months.

 

Source: Morningstar, July 6th 2020

 

International equity (yellow) has been outperforming US stocks (grey) since early June but has given back some of that outperformance more recently. However, EM equities (orange) have been on a run since mid-June, widening the performance gap over US equities.

Valuation gaps remain

At MASECO, we watch CAPE – a market valuation measure that uses real earnings per share over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. Changes in cyclically adjusted price earnings (CAPE) ratios are driven largely by price changes and to a lesser extent by changes to 10-year average earnings. US, International and EM regions all have a higher CAPE, as at the end of June, versus three months ago. However, valuation differences are still very large (US high, EM and International low) which is important when one considers the source of future expected returns.

 

Source: Research Affiliates, June 30th 2020

 

The CAPE of Emerging Markets equities is still at the 10th percentile compared to its own valuation history. In other words, 90% of all historic CAPE values have been higher than the current CAPE of 13.3x. US equities are still at the other end of the spectrum, its current CAPE of 29.9x is in the 95th percentile, meaning US equities have rarely been as expensive as they are today.

Therefore, from a long-term valuation perspective, our case is still intact for EM to outperform US stocks in the coming months or years.

Valuations: Asessing the change

Market Commentary

A month feels like an eternity in today’s unparalleled environment – markets sold off at a faster rate than at any point in history and found a base and bounced by entirely necessary fiscal and monetary stimulus. Many people are asking themselves if it is a good time to buy equities given current valuations? To be able to identify cheap or expensive equity markets, investors must, amongst other things, look to analyse and interpret the market and consider valuation ratios that compare fundamental data for equity indices such as book value or earnings with current prices (P/E or P/B).

Various valuation ratios exist, and each comes with its benefits and deficiencies (such as having no predictive power in the short term). One ratio MASECO takes most guidance from, because of its reasonable ability to predict long term (10y plus) equity returns, was developed by Campbell and Shiller in 1988: the cyclically adjusted price-to-earnings ratio (CAPE). It looks at a business’s current market price in relation to the average inflation-adjusted profits of the previous 10 years. The purpose of the 10-year period is to ensure that the profits are averaged over more than one business cycle and to account for different levels of inflation over the period.

Is the US equity market still expensive?

In the chart below, one can see that the average US CAPE since 1880 was 17. Its latest reading as at the end of March 2020 was 24.6 having fallen from 30.6 just 2 months earlier.

US Cape 1880-2020

Source: Yale University. March 2020

As one can see these CAPE numbers are above the long-term average. US equities have seemed expensive for the past few years and therefore most investors would see them as still being overpriced. There is an argument that a higher average CAPE is justified because we now live in a world of low interest rates however even if one takes this into account US equities are still looking dear.

Expected returns for US equities have increased from a low level

The good news is that it is possible to infer long-term return expectations from the assumption that CAPE returns to its long-term average. The bar charts below show the implied level of CAPE and implied long-term expected return at various levels of draw-down from the S&P 500’s peak of 33.86 on February 19th April 2020. A 30% equity market pullback implies a CAPE level near 22 and an increase in expected return of 1.7% a year for the next decade because of lower valuations.

This assumes a long-term fair value multiple of 17. For investors who believe that fair values multiple to be higher than 17 (because of lower interest rates today) these expectations will differ, but the point remains the same—the market’s drop translates into higher expected returns.
CAPE and Expected Returns Estimates at Different Market Prices

Source: “As Markets Burn”, Research Affiliates, April 2020

Investing always means you chose to buy one thing instead of another and, unless there is available cash, it also creates the need to sell another investment to finance that purchase. Therefore, it seems that one should look at multiple markets when considering how to allocate assets.

Changes in CAPE show little dispersion

Over the past 2 months, the CAPE for global equities has dropped from 22.6 to 17.7 a decline of 22%. Regional variations have been relatively small, with the UK and Europe having dropped the most by 24.4% and Asia ex Japan, where CAPE has fallen by only 18%.

Is Europe now the most attractive place to invest? Not really. Emerging Markets had the lowest CAPE ratio before the big market drop, and still remain the cheapest region. However, what if emerging markets are always the cheapest? In that case, an investor should not expect a big change in CAPE driven by a big change in price towards a long-term average.

Changes in CAPE

Source:Research Affiliates, April 2020

Comparisons should be across investments as well as across time

Just like it is possible to compare any value against a long-term average, it is possible to compare current market valuations against their historical maximum and minimum values. The below chart does just that for CAPE ratios of US, Japanese, UK, EAFE, and Emerging equity markets as of March 2020. The current CAPE ratio for US equities is the only value that remains in the top quartile. The rest of the world has current CAPE ratios, that are in the bottom quartile. In fact, stocks in Asia, Japan, and Emerging Markets each have a CAPE that even ranks in the bottom 5% of all their respective historical CAPE ratios.

If one believes that higher CAPE medium average should be applied for the US market (with lower interest rate) then one should apply the same logic for markets ex-US. This would imply that the rest of the world markets are even cheaper than otherwise would be expected!

Shiller P/E of selected markets (March 2020)

Source: This data is calculated by Research Affiliates LLC using data provided by MSCI Inc. and Bloomberg. The number shown on per region indicates the current P/E Shiller as per the date disclosed. The graph also indicates the Max Shiller P/E, the 75th percentile Shiller P/E, the Median Shiller P/E, the 25th percentile Shiller P/E, and the Minimum Shiller P/E per region, as illustrated for Japan’s region.

No holy grail exists in investing

While the above comparison looks like convincing information to act upon and make money by selling US equities and re-investing in the rest of the world, unfortunately it is not as simple. Just because an indicator has proven useful to forecast equity markets in the past, does not mean the same will hold in the future. For example, we all might experience economic environments, that have no historical precedent. And CAPE itself has some critics, just like other valuation ratios. The US market generally has a higher proportion of securities in the information technology sector when compared with other markets hence its higher CAPE versus others. Given the recent price moves in this sector this has given it a higher CAPE multiple.

The investment philosophy at MASECO leads us to be guided by the principles of both academic evidence as well as diversification at every level of investment thinking. So, while we view CAPE as one useful indicator, we would never “bet the house” on it. Instead, we budget a limited amount of risk to our regional equity allocation decisions. They are just one element in our approach to seek improved risk adjusted returns over the long term for our clientele. It is accompanied by other return drivers in both the asset allocation dimension (carry, trend, quality, etc) as well as the security selection (value, small cap, profitability, etc). While even these combinations can fail to deliver the desired outcome, the odds of success are improved.

Despite the recent recovery rally, one should also not forget, that the Covid-19 pandemic is a “known unknown”: Even as visibility of both economic and market consequences has recently increased , there are still unknowns over how long the pandemic will last, how prolific it will be and how long the lockdown order(s) will be needed.

This time isn’t different – Reports of value securities’ death are greatly exaggerated

Derive the intrinsic value of a company and compare it to the market price.  Buy if cheap and sell if expensive.[1]  Benjamin Graham and David Dodd wrote these words in their magnum opus, Security Analysis Principles and Technique in 1934. 

Essentially, they identified a way in which to move asset purchases from the realm of speculation to mathematical calculation.  Much later, Basu (1977) first published his academic paper on the superiority of value strategies in comparison to the general market.  “To the extent low P/E portfolios did earn superior returns on a risk-adjusted basis, the propositions of the price-ratio hypothesis on the relationship between investment performance of equity securities and their P/E ratios seem to be valid.”[2]  There’s been a prodigious measure of articles on the decline of value securities in the financial press over the past decade.  Have value stocks really lost their vigor?  According to Dimensional Fund Advisors, “Value stocks have underperformed growth stocks over the past decade. In the US, the annualized compound return has been 12.9% for value stocks, or those trading at a low price relative to their book value. That contrasts with 16.3% annualized compound return for growth stocks, or those with a high relative price.”[3]  This doesn’t necessarily mean that value stocks have underperformed, but rather that growth stocks have significantly outperformed.  In the graph below, it should be clear that value stocks are well within their margin of error in respect of expected return assumptions.  What should also be evident from the graph is the extent to which growth stocks have outperformed in recent history, thus creating a ripe opportunity for inaccurate causal inferences or generalizations suggesting this era is “different”.

As of June 30, 2019. In US dollars. Fama/French indices provided by Ken French. See Index Descriptions in the appendix for descriptions of Fama/French index data. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

“Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants.”[4]  It shouldn’t come as a surprise that having a 10-year negative premium, much like the last ten years in value, is not an unusual event.  It’s happened before in the US.  Furthermore, according to Research Affiliates, “If valuations were to mean-revert today, value will outperform growth by 35.3%.”[5]

As an investor, what is the appropriate course of action based on the information above?  For tactical investors, paring back growth equities might be a prudent decision.  However, if you’re investment horizon is long-term and you don’t need funds/income currently, make sure you’re rebalancing your portfolios according to your investment plan.  The great economist John Maynard Keynes once opined, “In the long run we are all dead.”  However, in the world of investments, in the long run, investments will achieve their expected returns.

Risk Warnings and Important Information

This article is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The value of investments can fall as well as rise.  You may not get back what you invest. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a reliable indicator of future results.

Although the information is based on data which MASECO considers reliable, MASECO gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such.

[1] Graham, B., Dodd, D.L. (1934).  Security Analysis Principles and Technique.  New York and London. McGraw-Hill Company Inc.

[2] Basu, S. (1977).  INVESTMENT PERFORMANCE OF COMMON STOCKS IN RELATION TO THEIR PRICE-EARNINGS RATIOS: A TEST OF THE EFFICIENT MARKET HYPOTHESIS. The Journal of Finance – Vol. XXXII, No. 3., pp. 663-682.

[3] Dimensional Fund Advisors.  https://us.dimensional.com/perspectives/value-judgments-viewing-the-premiums-performance-through-historys-lens

[4] Graham, B., Dodd, D.L. (1934).  Security Analysis Principles and Technique.  New York and London. McGraw-Hill Company Inc.

[5] Kalesnik, V., PhD, Reports of Value’s Death May Be Greatly Exagerated, Fall 2019, Research Affiliates Investment Symposium

Understanding Inverted Yield Curves and What They Mean to You

In March of this year, the US bond yield curve inverted. What does that mean? We must take a step back and understand what and how bond yields or interest rates are determined. The term structure sets forth the relationship between bond yields (interest rates) and different terms or maturities. When this is formally plotted out into a graph, we have what is known as the yield curve. This in turn plays a key role in market participants’ expectations of future changes in interest rates. Generally, yields or interest rates increase with longer maturities. This is what economists call a normal yield curve. In commodities the term is contango, where spot or current prices are lower than future prices. As was mentioned above, the US Treasury yield curve is currently inverted. That means that short term rates are higher than long-term rates. Again, in commodities this is known as backwardation, which is the opposite condition to that when prices are in contango. Please see the figure below as of 12 June 2019.

 

Current Yields

Source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield

As evidenced in the chart above, 1-month rates are higher than all those longer-term rates until you get to 20-year US government bonds.

What is the day-to-day impact for individuals and businesses? First, as the yield curve started to flatten earlier this year, and inverted for a short time in 2018, the Federal Reserve became much more dovish on hiking interest rates at the pace they initially set out in the 4th quarter of 2018. When the curve inverted, this has historically been a precursor to an impending recession. To test this hypothesis, a search of the US Treasury website shows that in the last 50 years, an inverted yield curve, one in which the majority of longer-term yields have been lower than shorter-term yields, has turned into a recession between 6 and 24 months following the inversion. From and economics standpoint, a recession means two consecutive quarters of negative Gross Domestic Product (GDP) growth. There are also times where just some of the longer-term rates are lower than the shorter-term ones. These periods have not been accurate predictors of an impending recession.

For businesses, they could find it more difficult to expand their operations due to higher borrowing costs on short-term loans. This is also true for consumers. Furthermore, consider households that have adjustable rate mortgages or ARMs. This means that in each anniversary of their loan, rates will jump. This situation applies to any debt instrument, including bonds. As an economy enters a recession, there will be a behavioral tendency for investors to seek shelter in safer investments. That means investors will move toward bonds, which will in turn increase bond prices and lower their yields. Unemployment will rise as businesses borrow less and the downward spiral of the economy will continue until some floor is met. As investors, it’s important to understand that these are temporary and expected occurrences in any economy. Investors need to be vigilant in maintaining their diversified portfolios and to continue to rebalance should equities decline in value.

Risk Warnings and Important Information

This article is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The value of investments can fall as well as rise. You may not get back what you invest. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a reliable indicator of future results.

Although the information is based on data which MASECO Asia considers reliable, MASECO Asia gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such.

MASECO Asia Limited (CE# BHR224) is authorized and regulated by the Securities and Futures Commission of Hong Kong to carry out Type 9 Regulated Activities.

Are We Close to CAPE Fear?

Way back in 1934, Benjamin Graham and David Dodd published a famous financial analysis tome called Security Analysis. They argued that one-year returns are too volatile to make any informed decision on the future of a firm’s stock price.

It was suggested that using data of five or even ten years to smooth the returns was a far better predictor of a security’s forward-looking price. If we then fast-forward to the 1980’s, “Stock Prices, Earnings and Expected Dividends” was published by John Campbell and Robert Shiller. They determined that “a long moving average of real earnings helps to forecast future real dividends” which are correlated with returns on equities. Shiller would eventually go on to use Graham and Dodd’s analysis as a way to value the stock market. Shiller and Campbell used market data from both estimated and actual earnings reports from the S&P index and found that the lower the CAPE (cyclically-adjusted price earnings), the higher the investors’ likely return from equities over the following 20 years.

Below is a graph of the CAPE over time and in relation to the current value of the S&P 500. As a point of reference, in the 20th century, the CAPE had an average value of 15.21 (Shiller, 2014). The rather disconcerting point is that as of the end of Q1 2019, the CAPE is double the long-term average.

Source: Online data from Robert Shiller, http://www.econ.yale.edu/~shiller/data.htm

Data as at May 2019

The graph below is a new version of Shiller’s CAPE which takes into consideration recent structural changes. As Shiller states on his webpage, “As of September 2018, I now also include an alternative version of CAPE that is somewhat different. As documented in Bunn & Shiller (2014) and Jivraj and Shiller (2017), changes in corporate payout policy (i. e. share repurchases rather than dividends have now become a dominant approach in the United States for cash distribution to shareholders) may affect the level of the CAPE ratio through changing the growth rate of earnings per share. This subsequently may affect the average of the real earnings per share used in the CAPE ratio. A total return CAPE corrects for this bias through reinvesting dividends into the price index and appropriately scaling the earnings per share.” This shows an even greater disparity between the long-term average and the current level.

Source: Online data from Robert Shiller, http://www.econ.yale.edu/~shiller/data.htm

Data as at September 2018

History has shown that when the CAPE is high, as it is now, it is suggested that buying equities when the stock market is expensive dampens subsequent returns. A review of current CAPE values in the US, developed ex-US, and emerging markets shows that greater relative value lies in the emerging market space. On the other hand, as CAPE is not a good predictor of short-term returns, returns from this current cycle can still be high; it’s impossible to predict the stock market return over the next 12 months based on valuation factors.

The last US recession ended in Q2 2009. The boom and bust, (better defined as expansion and contraction) business cycles of the U.S. economy averaged 38.7 months in expansion and 17.5 months in contraction between 1854 and 2009. According to the National Bureau of Economic Research, there were 33 business cycles between 1854 and 2009, with each full cycle lasting roughly 56 months on average. A recession from an economic standpoint consists of two consecutive quarters of negative GDP (Gross Domestic Product) growth. To put our current cycle in context, we are currently in month 119 (as of April 2019) of expansion.

If one combines the current degree and length of expansion in the US with an exceptionally high CAPE, it’s not a far leap to expect weaker growth for US markets over the medium term with the prospect of a recession being unsurprising from a historical standpoint. However, as we know, past events and performance are not necessarily predictive in nature.

Risk Warnings and Important Information

This article is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The value of investments can fall as well as rise. You may not get back what you invest. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a reliable indicator of future results.

Although the information is based on data which MASECO Asia considers reliable, MASECO Asia gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such.

MASECO Asia Limited (CE# BHR224) is authorized and regulated by the Securities and Futures Commission of Hong Kong to carry out Type 9 Regulated Activities.

Take Tesco’s Prudent Advice: The Magical Power of Compounding

In investing, time is your friend.  The longer an investor can commit funds to a strategy, the greater the possibility of success.  I’m sure, for many of us, we wish we could give our younger selves the advice to start saving earlier. In young adulthood, often times there are many demands on cash flow, and it can feel difficult to get ahead.  Working long hours in an entry-level job with student loans, rent, a car payment, and learning to deal with (gulp) taxes can be overwhelming.  The thought of setting aside precious net earnings for retirement which may be forty years or more down the road seems preposterous.

However, making a very small sacrifice now can have an exponentially powerful effect later in life.  Let’s look at the impact of starting to save and invest early vs later in life.  Assume we have four individuals at different stages of their lives who want to begin a monthly investment strategy with the aim of accumulating $1m by the time they reach age 65.  They are all aggressive investors and want to implement an equity-only strategy that will earn 10% on an annualized basis.  The table below shows the impact of compounding growth and time in the market (gross of costs):

Age 20 30 40 50
Monthly Investment $95.40 $263.39 $753.67 $2,412.72
Total Lifetime Cost of Investment $51,516 $110,624 $226,101 $434,290
Assumed Annualized Rate of Return 10% 10% 10% 10%
Value of Investment age 65* $1 million $1 million $1 million $1 million

 

*No assurance or guarantee can be given that an investment portfolio commenced at any age will reach a specific target value as the outcome will be dependent on various factors, such as market conditions, choice of asset allocation and costs.  The value of investments can go down as well as up.

The difference in the lifetime capital requirement is striking. We are faced with demands on our cash flow every day.  Some are fixed (mortgages, taxes, etc).  However, we all have an element of discretionary spending in our budget. The choice to dine out versus eat at home, buy a name brand vs generic product, fly economy vs business class…the list goes on. By making small changes to our discretionary spending, regardless of the phase of life we are in, we can direct more capital into long-term savings and vastly increase the likelihood of reaching our goals.

If you are reading this and you are in your 20s or 30s, take heed and consider making the choice to invest in your future financial well-being by adopting small changes in your lifestyle.  If you are closer to retirement (or perhaps in retirement), don’t lose heart.  It’s still important to regularly review your expenditure and consider if there areas in which you can reduce costs.  As the Tesco slogan says “Every Little Helps”.

Risk Warnings and Important Information

The value of investments can go down as well as up depending on market conditions and you may not get back the original amount invested. Investments involve risk and your capital is always at risk. Past performance is not a reliable indicator of future results. There is no guarantee strategies will be successful.

The above article does not take into account the specific goals or requirements of individuals. You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy.