May 29, 2007
Inflation, Correlation, and Market Valuation
In recent months, the quality of research on Wall Street has become nearly as loose as it was in the late 1990's, when bullish arguments were regularly repeated despite the ability to prove them false using basic arithmetic. Among the more bizarre finance articles that crossed my desk last week was one in the New York Times bemoaning the “stinginess” of investors and their “unwillingness” to drive P/E ratios higher. One chief investment strategist said of P/E expansion, “So far, it's been an untapped driver of returns.”
The article quoted a few figures - at the 2002 bear market trough, the P/E on the S&P 500 was 27.1, but the P/E is actually lower today. Failing to normalize the P/E for the position of earnings in its cycle, these figures overlook that earnings dropped by half during that bear market, and have since surged to record levels on record profit margins. The elevated P/E in 2002 reflected extremely depressed earnings, and normalized valuations that were still above-average from a historical perspective. The high but (only apparently) not extreme P/E multiples today are muted because earnings are unusually elevated, and will eventually “expand” even if prices are unchanged, unless profit margins remain at record levels forever.
On normalized earnings, the S&P 500 continues to be priced at the highest multiple in history except for the late 1990's bubble and the beginning of the subsequent plunge.
Inflation, correlation and market valuation
The same article quoted another chief investment strategist, who bubbled about “a perfect inverse correlation between inflation and P/E ratios.” The article included a table showing the average P/E on the S&P 500 given various rates of year-over-year inflation.
Now, one would require fantastic myopia and lack of reflection about how stocks are priced to believe that the trailing one-year rate of inflation should determine the fair, long-term value of stocks (which as noted last week, have “durations” of well beyond 50 years). It's hard to imagine that an investment professional would look at such a correlation and believe that stocks were actually worth the P/E implied by that analysis (then again, they do exactly that with the Fed Model). In any case, we can only hope that this strategist didn't intend to imply that the stock market's valuation can be justified using a single year-over year inflation rate.
Still, it's likely that many investors might have incorrectly come to that conclusion, so it's worth looking at the question carefully. Now, for starters, it is true that the historical data produce a clear inverse relationship between the trailing one-year rate of inflation and the P/E ratio on the S&P 500:
The real question is whether this is a “fair value” relationship. Once again, the proof of the pudding is in the eating. A good analyst should always check whether a model has meaningful implications for subsequent stock returns. In this case, when we look at the historical data, do we find that low rates of inflation actually justified high valuations, so that stocks could deliver attractive long-term rates of return (or even attractive inflation-adjusted returns) despite the high P/E ratios? Can investors really expect to price stocks at rich P/E multiples, based on a low trailing one-year rate of inflation, and yet avoid suffering poor subsequent long-term returns?
No. They cannot. As with the Fed Model, “correcting” the P/E using the prevailing rate of inflation destroys, rather than enhances, the ability to explain subsequent returns. Simply put, high valuations produce low long-term returns, and vice versa:
In short, looking at the historical data, we do observe that low trailing inflation rates have been associated with high P/E ratios, and that high trailing inflation rates have been associated with low P/E ratios. But – and this is crucial – we still find that those P/E ratios led to exactly the long-term consequences you would expect. High P/E ratios were associated with poor long-term returns, while low P/E ratios were associated with elevated long-term returns.
This result also holds on an inflation-adjusted basis, so it's also not the case that the rich P/E's were “fair” when returns were corrected for subsequent inflation.
What's really going on is that when inflation rates have been low, investors have had a historical tendency to overprice stocks on the basis of excessive optimism. When inflation rates have been high, investors have had a tendency underprice stocks on the basis of excessive pessimism. Much of the statistical relationship can be traced to the explosive inflation rates of the 1970's and the subsequent disinflation. It is not a “fair value” relationship, nor is it a relationship that we should necessarily depend on in the future.
If this “mispricing” interpretation is true, we would expect to find that high one-year rates of inflation have actually been related to high subsequent long-term rates of return, and low rates of year-over-year inflation have actually been related to poor subsequent long-term rates of return.
And in fact, that's exactly what we discover:
As noted above, these results also hold on an inflation-adjusted basis, so it's not the case for example, that the high returns were simply compensation for high subsequent inflation. To the contrary, the high inflation periods were typically followed by high nominal returns but lower inflation, making the subsequent returns look exceptional on an inflation-adjusted basis. In contrast, the low inflation periods were followed by poor nominal returns but slightly higher inflation, making the subsequent returns look even worse on an inflation-adjusted basis.
So although we might look to the year-over-year inflation rate in attempts to explain why P/E ratios might be high or low, we should emphatically not look to the year-over-year inflation rate in attempts to justify P/E ratios. The distinction here is crucial. A rich P/E multiple on the S&P 500 has historically been followed by poor long-term returns. Period. A low trailing inflation rate might be part of the explanation as to why investors might be willing to overprice stocks, but a low trailing inflation rate does not justify rich valuations, nor does it save investors from the consequences of that overpricing.
Again, we should not rely too strongly on the relationship between inflation rates and P/E ratios to persist in the future, since the data are heavily influenced by the 1970's inflation and the subsequent disinflation. When investors evaluate the long-term investment merit of stocks, they should focus directly on valuations, rather than assuming that long-term returns will have any particular relationship with short-term inflation rates.
Still, given that lower inflation rates tend to fuel excessive investor optimism and higher inflation rates tend to fuel pessimism, it does make sense to pay attention to inflation rates as part of a broader analysis. Specifically, when valuations are rich and inflation begins to trend higher, the potential outcomes for stocks can be particularly negative. In contrast, when valuations are depressed and inflation begins to trend lower, the potential outcomes for stocks can be particularly strong.
As a simple example, when the S&P 500 P/E has been below 15 and the year-over-year inflation rate has declined below its level of 6 months earlier, the S&P 500 has followed with average annual total returns of 19.22%. In contrast, when the P/E has been above 15 and the year-over-year inflation rate has advanced above its level of 6 months earlier, the S&P 500 has followed with average annual losses of -0.10%. Returns have been about average for intermediate cases (valuations rich but inflation falling, valuations depressed but inflation rising).
Presently, the year-over-year average of core and overall CPI inflation remains higher than it was 6 months ago, as are Treasury bond yields. Given rich valuations, these trends produce fairly pointed risks. Still, the evaluation of market conditions depends on an even wider variety of factors that further improve the partitioning and affect our determination of the prevailing “Market Climate” for stocks. Suffice it to say that we are fully hedged.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, moderately favorable price trends, and a combination of overvalued, overbought, overbullish, rising-yield conditions that has historically produced not only returns below Treasury bills, on average, but deep, abrupt “panic” declines. As always, that's not a forecast or an outcome that we need to rely upon – average returns below Treasury bills are sufficient reason to hedge our market exposure – but we certainly shouldn't rule out such a panic.
The Strategic Growth Fund continues to be fully hedged, with about a percent of assets allocated to a “staggered strike” configuration. It is important to remember that this position will add some “local” day-to-day fluctuations in Fund value, but that the overall difference between our current position and a flat, fully-hedged stance is only about 1% of assets. This basically reduces the implied interest rate we would otherwise earn on our hedge, but reinforces our downside protection. Consider it strong insurance that I would expect to substantially improve our defense against potential market weakness.
In bonds, the Market Climate last week was characterized by modestly unfavorable valuations and unfavorable yield pressures, holding the Strategic Total Return Fund to a short-duration position of about 2 years, mostly in TIPS. The Fund also holds just over 20% of assets in precious metals shares, where the Market Climate remains favorable on our measures.
Interest rate trends are pushing higher not only in the U.S., but globally. One might wonder – if there is so much “global liquidity,” why are interest rates rising everywhere? Credit spreads are perking up modestly too, but haven't yet exploded higher in a way that would reflect an oncoming recession or an easing of general inflation pressures.
What's really going on is not the creation of “global liquidity” – central banks worldwide are generally tightening. What investors have misconstrued as “global liquidity” is nothing but a combination of a) risk blindness among investors, and b) the U.S. going deep into debt to finance current consumption (both private and government spending), while China and other developing nations run huge surpluses to sell us that consumption. They then take the proceeds and buy a) Treasury securities, and b) our means of production. Piece by piece, we are selling off productive assets and claims to our future income, in return for present spending. That's not liquidity – it's reckless, voluntary subjugation of our future prosperity. Indeed, China recently agreed to buy a chunk of Blackstone Group, and its government is establishing additional means to invest its surpluses by purchasing U.S. assets.
Smartest comments of the week: Ray Dalio of Bridgewater Associates, who manages about $160 billion in assets for clients including central banks and foreign governments, quoted in Barron's:
“Our situation today is a modern-day version of the time before the Bretton Woods breakup. It is very much analogous to 1968, '69, and '70, a period in which we had large imbalances, a fixed exchange rate, and Japan and Germany bought our bonds, and then there was a rebalancing. China today is similar to Japan then, in transition from being an emerging economy, except it is about eight times as large. The imbalances are only going to increase, and there'll need to be an adjustment for that. This will lead to depreciation in the value of the dollar relative to emerging countries' currencies, particularly those in Asia . It is going to mean the Fed's tradeoff between inflation and growth is going to be more acute in the next couple of years.”
“We haven't had negative performance or positive performance for about the last 18 months or so. We haven't made money and we haven't lost money. There are always times when you are saying the world around you is doing things you think you don't want to participate in and, in fact, you want to bet against. In fact, 1998 and '99 were very much like that for us, and we made a lot of money when the stock market broke in the 2000-2002 time period. The biggest mistake in investing is almost implicit in your question. The biggest mistake in investing is believing the last three years is representative of what the next three years is going to be like. The most common mistake in the investment profession is to say, oh, it hasn't been good for me for the last 18 months and therefore I need to change what I'm doing. The real question is whether your judgment is sound or poor. ”
“Hedge funds and private-equity firms today are like the dot-coms in 2000: Ask for money and you'll get it. They bid up the prices of everything. The amount of money flowing is almost out of control, and it's making everything overvalued. A client of mine said it's like there are 11,000 planes in the sky and only 100 good pilots -- an accident is bound to happen. Just like the dot-com bust, the winners and losers will be sorted out but the technological advances won't stop. There is a greater differentiation of managers now than ever before. ”
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