An abrupt market drop causes a rally in gloom-n-doom
hypotheses. More than a few that landed in my inbox recently focused on the relationship
between corporate profits and GDP. The core theme was this: corporate profits
as a percentage of GDP exhibit a mean-reverting characteristic. Whenever they
overshoot too far from the mean, they fall back; and this isn’t good for
long-term equity returns. Current levels are close to historical highs, so equity
bears invoke the above to build a bear case. Historical references cite the
peaks hit in 1965/66 and 2006 as strong evidence for weak subsequent equity
performance.
History provides some insights. The following exhibit
uses after-tax corporate profits from NIPA and uses the Dow Jones Industrial
Average as a barometer of equity performance. The DJIA was chosen as a longish
history of prices was readily available. For comparative purposes, a similar exhibit
for the S&P 500 is appended later.
Only 2 out of the previous 9 occasions have been dreadful for
long-term equities. The
1965/66 peak (the so-called Kennedy-Johnson
peak) was followed by a long period of negative equity market returns. Something
had changed on this particular occasion compared to previous instances. The
2006 peak seems to be (so far) tracing the 1965 pattern. Indeed, in terms of
performance, the latest instance is unprecedented.
The S&P 500 shows a similar pattern, except that the 1965 peak
exhibited some divergence with the DJIA’s performance over the 2 and 3 year
time frames. The 1997 peak preceded a decent show by equities over the typical
time frames that a majority of market participants inhabit (1-3 years).
Given the above, the equity-bears’ argument for selling
equities on the premise of historically high corporate profits/GDP necessitates
a closer look.
One went about searching for the missing pieces that could
complete this jigsaw puzzle somewhat, and zeroed in on some metrics that to have a bearing on equity performance. Metrics included Robert
Shiller’s cyclically-adjusted P/E ratio (CAPE; real S&P 500 price divided
by last 10-year average real earnings), 10-year US Treasury yield, AAA
corporate bond yields and inflation (CPI).
Ceteris paribus, a high starting CAPE accompanying peaks might
be posited to set the stage for weak subsequent returns. High valuations and
high profits relative to GDP would imply that most of the positives were
already priced in by market participants; and slip-ups on profitability would
be perceived unkindly.
A closer look at
history
In investing, very often, the path taken to arrive at a
signpost has a strong influence on future course of events. The exhibit
below presents a 10 year picture; 5 years prior to the peak year and 5 years
subsequent to the peak year.
Cut to 1965: At the cusp
of 1965, the market came off a period of low inflation and general prosperity in
the 50s and 60s. Optimism buoyed by President Kennedy’s election in the early
60s, and followed by President Johnson’s Great Society program, stoked a rally in
equities. And then the Vietnam War escalated, degenerating into a deadlock, ultimately
entering the history books as a costly indulgence. Johnson’s Great Society dream
would remain a dream and inflation worries increased as a result of the war,
puncturing investor confidence. Proving market participants’ right, inflation inched
up through the 60s and 70s. 10-year Treasury yields inched up through the same period.
It appears that a high starting P/E + corporate profits / GDP
peak + high inflation + rising bond yields in the post-peak period set the
stage for weak equity performance.
Some caution is warranted, however, before forming a
provisional conjecture. Post-1941 performance dents this hypothesis. The World
War II peak was followed by a rise in inflation. Through 1941, average P/E was
reasonably high and inflation was low, similar to 1965. Ensuing equity
performance was strong, however. High valuation + peak + high inflation
had not succeeded in keeping equity returns in check. The outcome is interesting
considering that average inflation was higher post-1941 v/s post-1965.
The post-1974 performance was similar in behaviour to
post-1941. Things get more intriguing here as average inflation was high both before
and after the peak year and bond yields were well on their way to multi-decade
highs. Yet, equities did okay.
By 1997 investor optimism was running high again and the
CAPE was at elevated levels relative to history. Inflation was low and bond yields
had been trending down over the past 15 years. This peak, however, was followed
by a tepid show for equities over the medium/long-term.
Cut to 2006. CAPE was high, inflation and bond yields were reasonable.
But ensuing equities performance has given no cheer whatsoever (so far anyway).
In a nutshell, equities do not bear
a consistent static relationship with inflation or bond yields at all times. Valuation levels, however, are a different matter. But writing
equities off because corporate profits / GDP are at peak is a little simplistic,
in my opinion. Another important factor that these periods share is investor
sentiment. Psychology plays a pivotal role in determining future outcomes and
is, unfortunately, the least considered variable. The character of investor sentiment
changed post-1965 due to a multitude of factors (Vietnam War inflation, Cold War etc.), resulting in bearishness, and
was probably a contributory influence in keeping returns down. The vicissitudes
of the human mind has trumped cold reality repeatedly through history.
Could this time be
different?
A summary of the present: Corporate profits / GDP are
presently at elevated levels relative to history, inflation is reasonably high
considering the recessionary backdrop and bond yields are at historically low
levels with little room to fall further. Are equities doomed, or does this
represent an attractive entry point? Considering the above exposition one is
reluctant to proffer a conjecture.
At 20x, the S&P CAPE is high relative to the past and broad
interest rates are expected to stay low over the foreseeable future. Given the
repeatedly unsuccessful attempts at band-aiding the global economy, few believe
the present downturn to saunter into history books anytime soon. The difference
between buying and selling the broad index is essentially a bet on the future pattern
of investor sentiment. If the latter does not turn up, a purchase now is likely
to face an unsatisfactory outcome. In relative terms, however, Germany seems to
offer better value. The current CAPE of ~12x is close to 30-year lows. Throw in
reasonably attractive dividend yields (~4.5%), and the DAX looks like a better
basket to be long in. There is, however, the real risk of low valuations morphing
into value traps and the high dividend yields potentially signalling lower
dividends in the future...well...
S&P 500: High CAPE + historically low bond yields +
medium inflation + poor sentiment + mixed history = Trance
DAX: Low CAPE + attractive dividend yield + King Kong of
the EUR + poor sentiment = (lesser) Trance
It seems a better proposition to dwell on individual
businesses rather than participating in a broad index. High dividend yield equities
combined with low dividend payout ratios in industries that are relatively
recession-resistant is a theme that the mind is drawn to.
Sometimes, history accentuates an investor’s Uncertainty Quotient.
It’s a bittersweet feeling.
Schizophrenic markets do not help either.
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