April 5, 2004
Aristotle viewed tragedy as the result of a tightly connected chain of causes and effects, usually brought on by the crucial oversight or miscalculation of a basically good person, and carried inevitably to catastrophe by the fundamental order of the universe. A good tragedy inspires not only pity and empathy, but also fear of small mistakes and human fallibility.
More than a few tragic scripts are being written in the financial markets here. Not least among them is the disappointment that investors invite when they assume that stock prices are simply a thermometer of business conditions, with no relationship to valuations.
Probably the most common argument for stocks here is that “the economy is improving.” Thus, the logic goes, stock prices should follow. Two additional elements seem to add “legs” to the belief that stocks are safe long-term investments here. The first is that interest rates are low, thus stock yields can be similarly low (i.e. P/E ratios can remain high). Second, economic growth has been much more stable over the past decade than in prior decades, thus, the argument goes, the risk premium on stocks can be considerably lower.
Good economic growth, low interest rates, and a justification for low risk premiums too. What better “sweet spot” could an investor want?
Unfortunately, the acceptance of this argument is precisely the “incentive moment” that starts the cause-and-effect chain of the Aristotelian tragedy.
In previous commentaries, I've noted that statistically, it is stock prices that lead the economy, most definitely not the other way around. In fact, quarters with above average economic growth tend to be accompanied and even followed by below-average stock market performance.
Seeing the fallacy in the arguments about interest rates and economic stability requires an understanding of duration. Essentially, the higher the valuation and lower the yield on an investment, the longer its effective “life,” and the longer an investor's horizon must be in order to be indifferent to price fluctuations. The duration of the S&P 500 is essentially measured by its price/dividend ratio, which is currently over 60. For much of the past century, the yield on the S&P 500 hovered around 4%, resulting in a duration closer to 25.
What this means, in practical terms, is that an investor in the past required only a 25 year investment horizon in order to justify a fully invested position in stocks, without worrying about the particular path that stock prices would travel over that investment horizon. Today, investors with horizons of less than 60 years are heavily dependent on the precise path that stock prices take over time. Certainly, investors with horizons of 10-15 years have very little predictability about their financial future if they choose to be fully invested in stocks through a buy-and-hold strategy.
The extraordinarily long duration of stocks here makes the use of say, a 10-year Treasury yield a completely inappropriate basis on which to price stocks. Moreover, unless we can add the additional assumption that future economic growth over the coming 60 years will be as stable as during the past decade (essentially pronouncing the business cycle obsolete), it is equally inappropriate to assume that risk premiums should remain durably low.
Estimating long-term returns
If we abandon the fallacy that stock prices should necessarily follow the economy, and that their valuations should be pegged to 10-year Treasuries and low risk premium assumptions, where does that leave us? Quite simply, it leaves us in a world where stocks are priced to deliver very disappointing long-term returns from current price levels.
We don't have to assume that P/E ratios will move back to single digits in order to arrive at this result. Historically, when S&P 500 earnings have reached a new high, the P/E on the S&P 500 has averaged just 12. If we look at the price-to-peak earnings ratio over history, the average is just 14 (the median is 11). On the basis of anything close to normal relationships between stocks and earnings, it would be implausible to assume that the price-to-peak earnings ratio will not touch its historical norm at some point in the next, say, 20 years.
What would be the result of that future event on stock returns? Well, we know that measured from peak-to-peak, S&P 500 earnings have grown no faster than 6% annually, regardless of whether we look back 10, 20, 50 or 100 years. So let's put the data together.
The S&P 500 is currently trading near 22 times prior peak earnings. At 6% earnings growth and a P/E ratio that merely touches its historical average two decades from now, the S&P 500 would deliver capital gains of [(1.06)*(14/22)^.05 – 1 = ] 3.63% annually. Add in an average dividend yield of about 2%, and stocks will probably deliver total returns of about 5.63% annually if stocks merely touch historically normal valuations two decades from now.
Alternatively, one could argue that the peak earnings of 2000 need to be expanded at a 6% annual rate, which would take earnings to a new high today, so that price-to- attainable -earnings is currently just 18. Which is fine, except then our future bogey drops to 12, which is the average P/E multiple on the S&P 500, restricted to periods when earnings were actually at a new high. Similar calculations then indicate that the 20-year total return on the S&P 500 would be about 5.87% annually if stocks merely touch historically normal valuations in the future. Not much difference.
Moreover, if we assume that stocks will touch normal valuations one decade from now, the probable total return on the S&P 500 drops to less than 3.5% annually over that period. That's the number that long-term investors ought to be comparing to 10-year Treasury yields. Tragic.
FASB requires option expensing
In a small victory for investors last week, the Financial Accounting Standards Board mandated that options must be expensed on the income statement.
Frankly, I was disappointed that the rule didn't go further. Options do not represent a one-time expense to investors, but are alive until they are exercised. They should be expensed as an annual accrual with a cumulative accrual of either stock price at exercise minus strike price, or zero, depending on whether or not they are exercised (see How and why stock options should be expensed from corporate earnings on this website).
About a year ago, the FASB inquired whether I would also treat other unexercised call options and stock warrants issued by a company in the same way (including the embedded call in convertible debt). Here is how I replied:
“My impression is that options issued to employees and management, as compensation for operating activities, should be expensed in the derivation of income from operations. Options issued as part of financing activities, or embedded into convertible bonds, are like other derivative instruments which change the nature of one financial instrument into another (such as interest rate or currency swaps). These options would most appropriately be recognized elsewhere in the statement of comprehensive income.
“The essential argument is that options represent a liability from the standpoint of existing owners of the firm, with an uncertain and therefore accruable cost to shareholders. An effective treatment of options expense should recognize them not as a one-time event on issuance, but rather as a sequence of accruals with a cumulative value of either zero (if unexercised) or the security value minus the strike price as of the date of exercise. This sort of treatment also makes “theoretical value” arguments much less pointed, since differences in theoretical values alter only the distribution of these accruals over time – not their cumulative total.”
Our proxy voting guidelines regarding option-based compensation are detailed in our mission statement. We will continue to vote proxies against such plans, particularly if the current one-time, non-accrual expensing rules are finalized in their existing form.
Employment – good news if it continues
Friday's employment report drew an extremely strong response from the financial markets. Monthly payroll grew by 308,000, which is about two full months of typical labor force growth. The unemployment rate actually ticked higher, from 5.6% to 5.7%, as some discouraged workers re-entered the labor force. The Labor Department couldn't quite bring itself to admit this, so it described the unemployment rate as “about unchanged.”
The good news is that above-average employment figures tend to propagate, so that absent any “shocks” or well-defined shifts in economic conditions, job growth tends to be followed by job growth. What doesn't seem so clear to the markets is how unimpressive Friday's employment figures are, except in the context of very recent history.
Historically, monthly payroll employment has grown at an average rate of 0.18% (about 235,000 jobs a month based on the current labor force), with a standard deviation of 0.23% (300,000 jobs). Moreover, the sampling error in the employment figures is similarly large. As the employment situation explanatory note indicates, “at an unemployment rate of around 4 percent, the 90-percent confidence interval for the monthly change in unemployment is about +/- 270,000… These figures do not mean that the sample results are off by these magnitudes, but rather that the “true” over-the-month change lies within this interval. When this range includes values of less than zero, we could not say with confidence that employment had, in fact, increased.”
In short, Friday's figures were good news, not to be taken with a grain of salt, but not to be swallowed whole and projected indefinitely either.
As a statistical note, the 308,000 monthly employment figure had a t-statistic of about 0.24, meaning that it was about one-quarter of one standard deviation above typical levels of monthly employment growth (235,000). That's certainly not “statistically significant” at any reasonable level of confidence, and wouldn't be even if the null hypothesis was zero job growth rather than mean job growth. Despite the upward revisions in January and February figures, the employment growth of 513,000 jobs in the past 3 months has a similar, but negative t-statistic of –0.26. To the extent that the longer data set is more informative, it's clear that we won't know enough about the true employment picture until we get confirming job growth in the next few months.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and still modestly (though tenuously) favorable market action. This is certainly not a market without considerable risk, and the recent rally has cleared the oversold condition that had temporarily justified call option positions. At present, the Strategic Growth Fund remains fully invested in a broadly diversified portfolio of individual stocks, with about 50% of that value hedged against the impact of market fluctuations using offsetting short positions in the S&P 100 and Russell 2000 indices. In addition, the Fund continues to hold a “contingent” put option position capable of hedging an additional 45% of the Fund's exposure to market fluctuations in the event of a substantial market decline. These positions should not be considered “bearish calls” and do not indicate expectations about a market decline. Rather, they reflect the current combination of unusually hostile valuations and emerging breakdowns in the internal condition of the market.
I've noted the extreme condition of bullish sentiment and insider sales in prior commentaries. It's probably appropriate to add that new stock issuance is now rivaling the volume seen at the market's final peak in 2000. While some observers have pointed to this as a healthy sign of investor demand for stocks, I still think that John Brooks' 1973 remark from The Go-Go Years is more apt: “If one fact is glaringly clear in stock market history, it is that a new-issues craze is always the last stage of a dangerous boom – a warning of impending disaster almost as infallible as Cheyne-Stokes breathing is a warning of impending death.”
As a side note, it should not be assumed that the Strategic Growth Fund will generally take a hedged position during “bull markets,” and there is nothing inherent in our approach or in historical evidence that would lead me to expect our approach to “generally” lag market advances. The issue at present is what constitutes normal valuations. Based on our research on reliable measures of valuation (as well as unreliable ones like the Fed Model), current valuations appear stratospheric. To fail to defend the long-term investment capital of our shareholders merely on the basis of positive but increasingly fragile speculative merit would violate our most basic concepts of risk management.
That said, at our current level of hedging, I believe that it would be difficult for the Strategic Growth Fund to outperform substantial market advances over very short periods. To do so would currently require our stock holdings to gain at a rate in excess of 1.5 times the market's advance. At the same time, our hedge position is anything but static, and our stock holdings do not closely mirror any market index, so it is not at all clear that the Fund's returns would lag an extended market advance that occurs at a historically typical rate. I don't rule out such an advance, but as long-term investors, the market's prevailing return/risk profile matters significantly. We don't have enough evidence from valuations to justify a substantial exposure to market risk on that basis.
In contrast, the Market Climate of the bond market improved late last week. That Climate is now characterized by modestly favorable valuations and modestly favorable market action. The Strategic Total Return Fund currently has a duration of approximately 6 years, meaning that a 1% (100 basis point) change in interest rates would be expected to affect the Fund's value by roughly 6% on the basis of bond price fluctuations.
The market's reaction to the Friday employment report affected virtually all of our holdings in the Total Return Fund. Treasury bonds fell sharply. We had already added modestly to our positions on Thursday's weakness, which as usual, had everything to do with prevailing conditions and nothing to do with speculation about Friday's employment report. We increased our position further on Friday's price weakness, and are currently comfortable with a duration of 6 years, which is roughly in line with that of the overall bond market and is neither conservative nor aggressive (the Fund has the ability to hold portfolio durations as high as 15 years, but this would occur only if interest rates were quite high and market action was particularly favorable). Inflation protected securities and precious metals shares also fell on Friday, all of which accounted for a deeper-than-normal 1% pullback in Fund value that day.
New from Bill Hester: Long Term Stock Returns: How Low Will They Go?
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