U.S. equities cheap for a rea­son

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

By most mea­sures, US equities are not cheap. Yet many in­vestors re­main over­weight, be­liev­ing that in a world of ul­tra-low in­ter­est rates and neg­a­tive bond yields, eq­uity val­u­a­tions should be higher be­cause fu­ture cash flows are now dis­counted at a much lower rate than in the past. At first glance, the eq­uity risk premium — the ex­pected re­turn on stocks over and above the risk-free rate — ap­pears to sup­port this be­lief. At more than one stan­dard de­vi­a­tion above its long term av­er­age, his­tory sug­gests the eq­uity risk premium should re­vert to­wards its mean, im­ply­ing fur­ther val­u­a­tion gains are prob­a­ble. Alas, we can­not share this op­ti­mism.

The pre­cise def­i­ni­tion of the eq­uity risk premium is the sub­ject of end­less aca­demic de­bate. For this dis­cus­sion, we use div­i­dend yields com­pared to real long term bond yields. The rea­son div­i­dend yield is our pre­ferred nu­mer­a­tor is that earn­ings yield, the other com­monly used mea­sure, as­sumes undis­tributed prof­its can be rein­vested at cur­rent earn­ings yields, which may be un­re­al­is­tic. And we use real bond yields be­cause div­i­dend yields are per­ceived as a “real” rather than a “nom­i­nal” mea­sure. By this for­mula, the US eq­uity risk premium is cur­rently one stan­dard de­vi­a­tion above its 50year av­er­age — and has been at this el­e­vated level ever since Septem­ber 2011, when the Fed­eral Re­serve launched Op­er­a­tion Twist to drive down the long end of the curve.

This isn’t the first oc­ca­sion the eq­uity risk premium has re­mained ab­nor­mally high for an ex­tended time. In the last 100 years, there have been three such pe­ri­ods. Episodes of el­e­vated eq­uity risk pre­mi­ums were as­so­ci­ated with both the First and the Sec­ond World War, while the third pe­riod co­in­cided with the era of Key­ne­sian poli­cies in the late 1970s, even though cor­po­rate earn­ings were grow­ing rapidly at the time.

What these three episodes have in com­mon with each other, and with to­day, is that each co­in­cided with a pe­riod of neg­a­tive real in­ter­est rates. Of course, there have been other in­ter­ludes of neg­a­tive real rates in the last 100 years, and in those too the eq­uity risk premium rose. But be­cause the start­ing points were gen­er­ally lower and the du­ra­tion of the episodes shorter, the eq­uity risk premium nei­ther got so high, nor re­mained el­e­vated for so long, as to­day.

So why does the eq­uity risk premium go up and stay up when the Fed is be­ing ac­com­moda­tive? Two pos­si­ble ex­pla­na­tions spring to mind:

1) In­vestors re­gard cen­tral bank pol­icy counter-pro­duc­tive and un­sus­tain­able.



Dur­ing the 1970s, as Key­ne­sian poli­cies pushed in­fla­tion higher, in­vestors gave more weight to mount­ing long term un­cer­tain­ties than to ris­ing earn­ings growth. To­day with the Fed again in Key­ne­sian mode, in­vestors again fear a pol­icy mis­take. Few share the Fed’s be­lief that ar­ti­fi­cially de­pressed in­ter­est rates will per­suade peo­ple to bring for­ward fu­ture de­mand, which in turn will en­cour­age en­trepreneurs to in­vest more. In­stead, in­vestors worry that a false cost of cap­i­tal makes an un­sta­ble foun­da­tion for fi­nan­cial mar­kets, and that the longer it per­sists, the greater the risk of an un­happy end­ing.

2) In­vestors re­gard the cur­rent ul­tra-low in­ter­est rate pol­icy as an ac­knowl­edge­ment of the struc­tural weak­ness of the econ­omy, and of the in­ef­fec­tive­ness of mon­e­tary

pol­icy to rem­edy the sit­u­a­tion.

Time and again, the Fed has been forced to ex­tend its un­con­ven­tional pol­icy, a sig­nal that the cur­rent cy­cle is ab­nor­mal and that the econ­omy could be sink­ing into a sec­u­lar stag­na­tion. Yet af­ter al­most eight years, there is lit­tle sign that the un­con­ven­tional pol­icy is work­ing. For in­vestors, a real rate kept low by stag­na­tion is no cause for cel­e­bra­tion.

If there is any truth to these ex­pla­na­tions, US equities are an unattrac­tive in­vest­ment de­spite their high risk premium. What’s more, this ar­gu­ment does not ap­ply solely to the US. Other ma­jor de­vel­oped mar­kets have seen sim­i­lar widen­ing of their eq­uity risk pre­mi­ums, start­ing from the times their cen­tral banks de­cided to em­bark on easy mon­e­tary poli­cies. The ob­verse of this trend is that in re­cent months safe haven in­vest­ments such as the yen, gold and sovereign bonds have all ral­lied sig­nif­i­cantly, em­pha­sis­ing the con­ser­va­tivism of in­vestors.

At its heart, the ques­tion “are equities cheap?” cen­ters around the im­pli­ca­tions of low in­ter­est rates. Bulls jus­tify their view by cit­ing low in­ter­est rates as the rea­son to re­duce the dis­count rate they ap­ply in their mod­els of fu­ture earn­ings, so push­ing up the present value of equities. But if cen­tral banks are right to worry about growth (and in­deed if cen­tral banks are them­selves the cause of wor­ries about growth) then prof­its will con­tinue to dis­ap­point, and an even lower dis­count rate will be needed to off­set cash flow fore­casts that keep get­ting re­vised down­wards. Per­haps there is still room for the dis­count rate to go even lower, but the very fact that in­vestors are re­ly­ing on a con­stantly fall­ing dis­count rate to jus­tify their po­si­tions is it­self a cause for con­sid­er­able con­cern.

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