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Stock Market Valuations Following the Great Moderation

Economic Volatility Tends to Lower Valuation Norms in the Bull Markets that Follow

William Hester, CFA
February 2009
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By the end of this month the U.S. economy will have been in recession 20 percent of the last decade.

The last time the economy spent so much of the proceeding 10 years contracting was nearly 20 years ago, a period that included both the early 1980's recessions and the 1990-1991 recession. And recent reports show that GDP contracted at its fastest rate since the early 1980's and that the rate of inflation has collapsed from 5.6 percent to almost zero.

This renewed volatility in output and inflation looks like it will bring at least a temporary end to the nearly 25-year period of generally falling economic volatility. This falling volatility was seen not only in the broad measures like economic output and headline inflation, but also in consumption and residential housing and a slew of other indicators. Economists labeled it The Great Moderation. During this period the volatility of GDP growth collapsed by half while inflation volatility dropped 40 percent. From 1950 to 1985 the economy spent an average of 20 percent of the time in recession. From 1985 through 2007 the average time spent in recession was 7 percent.

There were a number of theories put forth to explain the economy's more moderate swings. They can be broadly placed into three groups: better monetary policy, structural change, and good luck. With each of the explanations being stressed tested over the last year, it's worth taking a look at each one to see which held up. This process may help in determining if a return to a more moderate glide path in the near future is likely or not.

The first argument rested on the idea that those in charge of administering monetary policy had learned from the past and they were not about to repeat previous mistakes. One adherent to this school of thought was Ben Bernanke, who in a speech in 2004, as a Fed Governor, argued that improved monetary policy was an important contributor to the Great Moderation. In the speech he put forth a number of reasons why monetary policy had improved, including that the Federal Reserve was more vigilant against a rise in inflation following the experience of the 1970's and that the Central Bank had earned the confidence of spenders so inflation expectations had become well anchored.

Another argument Mr. Bernanke made was that the Federal Reserve now had a better understanding of the economy and the role monetary policy plays in managing the economy. To make the case that policy makers had learned from the past he referenced two models created by economist John Taylor. Bernanke referenced the Stanford economist's well-known Taylor Rule and his lesser known Taylor Curve. The Taylor Curve, which is from John Taylor's earlier work, attempts to represent the combinations of output volatility and inflation volatility available to policy makers when setting interest rates. The better known Taylor Rule suggests an overnight Fed Funds rate based on deviations in inflation and output from desired levels.

Mr. Bernanke essentially argued that the Federal Reserve's mistakes in the 1960's and 1970's were the result of setting policy rates that differed from rule-of-thumb models such as the Taylor Rule. This was partly because the Federal Reserve thought they could finely manage the economy's contractions with interest rate policy and partly because inflation was thought to be purely the result of exogenous shocks to the economy. But during Greenspan's chairmanship up to about 2004 whether by coincidence or choice - the Federal Funds rate had been set in close proximity of the rate suggested by the Taylor Rule, which resulted in better behaved inflation and output.

The irony of this is that at the time of the speech the Taylor Rule was suggesting a rate of almost 4 percent, while the Federal Reserve maintained its target rate of 1 percent. This of course hasn't gone unnoticed by John Taylor, who has written a number of papers over the last year showing empirically that the Federal Reserve's interest rate policy during this period was an important catalyst of the housing bubble and therefore influential in the current problems the economy is experiencing.

The second set of explanations relies on structural changes, two examples being better inventory management and a shift in the composition of the labor force toward a larger service sector. Permanently improved inventory management seemed like one of the easier-to-defend explanations for the Great Moderation. With the large investments in computerized inventory systems that companies made in the late 1990's and the widespread adoption of the internet it seemed companies would always be able to hold just enough product to keep the shelves from filling up. The data earlier this decade supported these assumptions. The Census Bureau's Inventory to Sales Ratio had been persistently declining this decade, from a high of 1.45 to a low of 1.23 reached last June.

More recently it looks like a portion of the weakness in the economy is coming from the more traditional inventory-led slowdown. While business inventories are slowing, sales are slowing more quickly. The recent GDP report implied that corporations may need to curtail production further this quarter to offset rising levels of inventory. Since June the inventory to sales ratio has given back the last eight years of improvement. The back up in the ratio looks much like the change in the ratio during the 1974 recession and again in the back-to-back recessions of the early 1980's, and a lot less like the more mild changes during the 1991 and 2001 recessions.

The fact that the economy has been shifting its composition of jobs from manufacturing to service-related employment is the explanation that is probably holding up best. The worse job losses have been focused in construction (where the number of jobs is down almost 10 percent from a year ago), durable goods (9 percent), and manufacturing (7.5 percent). More recently, though, job losses in the retail sector and business services have been accelerating. These will be important sectors to watch at the recession grinds on.

Prior to the peak in the economy, estimates varied about the role that good fortune played in explaining the Great Moderation. Mr. Bernanke implicitly gave it low odds, assigning more weight to improved monetary policy. Others thought luck played a larger role. Harvard economist James Stock and Princeton economist Mark Watson came at the problem empirically in a paper earlier this decade. They suggested that about half of the moderation in the economy came from good luck in the form of smaller economic disturbances. They also suggested that a return to more turbulent times was likely once the current period of good fortune ended.

Considering that the Federal Reserve's choice of discretion over rules-based guidance in setting policy ultimately proved unsettling, that inventories are rapidly piling up versus the drop in sales, and that service-related jobs are beginning to feel the brunt of the slow down, Good Luck may end up explaining the bulk of the Great Moderation.

Moderation in Valuation

What will more economic variability mean for stock valuations during the next bull market? Economic stability has generally been associated with high multiples while greater amounts of volatility in economic data have coincided with low multiples. The graph below shows this by graphing the volatility in inflation (measured by the 4-year standard deviation) and the coinciding price-to-peak earnings multiple for the S&P 500. (In the discussions below I mostly show typical valuation levels and total returns versus the volatility in inflation. But the variability in inflation and the variability in economic output are highly correlated, so the patterns look mostly the same under either analysis.)

As John Hussman noted in Inflation, Correlation, and Market Valuation , low inflation may often coincide with high multiples, but they don't justify them. Investors have a tendency to overprice stocks when inflation is low, setting themselves up for lower long-term returns following these periods.

We see the same results when we look at the volatility of inflation. The graph below shows the average returns following varying periods of inflation volatility. The data show that high returns follow periods of high volatility in inflation and lower returns follow periods of lower variability in inflation.

Investor Memory

Financial markets may be forward looking but the investors that make up those markets have long memories. In the 1970's bond investors persistently underestimated the rate of inflation, which squeezed their nominal returns. They didn't soon forget. Inflation peaked in 1980 but bond yields kept rising for another two years. The gap between sky-high bond yields and the rate of inflation in the early 1980's was almost 10 percentage points. It wasn't until the last five years that the yield on the 10-year note consistently traded between 1 and 2 percentage points above inflation, which was the typical spread prior to the 1970's.

Stock investors are the same way. As higher economic volatility comes at more regular intervals investors begin to expect that volatility and pay less for stock market earnings because they are less dependable over the near term. The graph below is one way to show this. The red line, which is scaled on the left axis, shows the earnings yield of the S&P 500. It uses peak earnings and it's lagged by 6 months. It shows that the recent stock market decline has pushed the earnings yield above 10 percent. This is an attractive earnings yield relative to the last 25 years, but not as attractive as levels reached at the market bottoms of 1974 and 1982. The blue line attempts to capture the expectations of investors for economic variability based on the recent past. It sums the percent of time the US economy was in recession over the prior decade and the current rate of inflation. With near-zero inflation, it's currently about 20.

The lines diverge most noticeably in the early 1990's when the early 1980's recessions dropped out of the calculation. More recently the line has leapt as the current recession lengthens. But generally the graph shows that with any combination of a greater amount of time spent in recession or a higher level of inflation, stock investors tend to demand lower prices and higher yields.

As the first graph in the text shows and this graph confirms, it's extremely rare to see high P/E multiples during (or even following) periods of high economic volatility. The average price-to-peak earnings multiple when the volatility of inflation has been in the lowest fifth of its readings is 20. When volatility has been in the highest quintile, the average price-to-peak earnings multiple has been 9.3. So the future volatility of output and inflation may play an important role in the extent of the total gains achieved during the next bull market. The two periods with the highest full-cycle gains (including both bull and bear market) since 1960 came between 1982 and 1987, where P/E multiples expanded from 8 to almost 20, and from 1990 through 1998, where multiples increased from 11 to 28. During both periods the volatility of output and inflation collapsed. Bull markets that run to 19 or 20 times earnings, or above, most often coincide with low or declining levels of economic variability.

Based on the chart above, current levels of valuation look attractive when compared with the current sum of the percent of the previous decade the economy was in recession and the CPI. Of course, there could be an information component in that divergence. Investors may be expecting economic volatility to continue to rise. That's also one of the risks of the market moving to a lower level of valuation on a sustained basis. The market bottoms of 1974 and the early 1980's coincided with a large percentage of the previous decade in recession and high inflation. If investors begin to expect that the economy in 2009 and 2010 will act similarly, the valuations of those previous periods can't be ruled out.

Considering recent economic data, the best explanation for the Great Moderation was "good luck." The disturbances and exogenous shocks to the economy were fewer and less destructive during this period. That good luck may return, followed by a lower amount of variability in output and in inflation and a return to multiples that regularly reach 20 times and above. But if more regular recessions and higher inflation volatility are here to stay, investors may want to adjust their assumptions of the typical peak P/E multiple downward.


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