Are stocks becoming less risky?
Two weeks ago I introduced CAPE as a smoothed price earnings ratio of the whole market as created by Robert Shiller.
The point of the exercise was to show that a neither a CAPE ratio of 25 nor 15 shows that the stock market is either too high or too low. The use of a 100 year average of CAPE as a benchmark is fundamentally flawed.
In my first post I pointed out that because of a super cycle in interest rates since 1948 one would expect price earnings ratios to vary substantially over long periods (see post here). In particular one would expect a fair value price earnings ratio, hence CAPE, to be increasing significantly since 1982.
Last week I explained how since 1948, with company investment in intangibles of lasting value decreasing reported net earnings, one would have expected to see increasing fair value price earnings ratios. As a result, one would have expected to see CAPE increasing significantly since 1948. (see post here).
CAPE has increased since 1982 and in part this is because of these two phenomena. The truth is that since 1982 an increasing ratio for CAPE by itself does not show the market is overpriced. It may be the result of interest rates and investment in intangibles.
There is something else at play.
Financial markets have given investors in common shares a return edge over bonds. U.S. Treasury Bonds with a ten year term are thought of as being risk free; never mind that they expose investors to inflation and currency risks. Over the long haul common shares have generated a return of between 4% and 6% per annum in excess of risk free bonds. There are different ways to calculate the Equity Risk Premium and so different authors give someone different values. This excess return is called the Equity Risk Premium. It is said to reward investors in common shares for the added riskiness of common shares. Holders of common shares stand behind bond holders in their claim on the assets of a company.
The following chart shows the U.S. Equity Risk Premium from 1900 to present. We are most interested in the period 1948 to the present because this is the period I have focused on with respect to the super-cycle in interest rates and the secular upward trend in investment in intangibles. I have drawn a red line that roughly equates with a linear regression over this period. About half the data are above the red line and half below.
Two things are notable from the chart. First, the red line slopes down to the right. Second, the volatility of the Equity Risk Premium seems to be decreasing. The downward slope means that as the decades have gone by common stocks have come to be seen as less risky. That is, investors are not earning as large a premium today as 70 years ago.
With the Equity Risk Premium declining over the decades one would expect price earnings ratios to increase. That is, stock prices will go up, thus decreasing expected returns, thus closing the premium gap between stocks and risk free bonds. The weird thing about this is that as prices get higher they are not getting overpriced. They are simply repricing to a level to reflect a lower Equity Risk Premium. The result is that price earnings ratios will go up without one being able to say the increased price earnings ratio shows stocks are overpriced. I leave it to readers to reflect on what happens if CAPE marches quietly higher in the decades to come.
I can offer some hesitant explanation as to why that is so. I caution readers that I am only an investor, not an economist or chartered financial analyst. But, read on.
Stock market regulation has changed over the decades increasing transparency and reporting, thus decreasing the riskiness of stocks; Liquidity in the stock market has deepened thus reducing risks. One can add other ideas to this narrative.
As for the second observation, that volatility of the Equity Risk Premium is decreasing, it may be a kind of great moderation caused by interventions by the Federal Reserve. Who knows?
So let’s take another look at the CAPE chart. I have drawn the red line to show expected direction and period of the impact of a lower Equity Risk Premium.
Pulling all of this together, we see that since 1982, some 40 years, one would have expected CAPE values to increase as a result of lower interest rates, higher company investment in intangibles and a lower Equity Risk Premium. The point of all this is that a fair price CAPE of 15, decades ago, does not mean that a CAPE of 25 today indicates an overpriced market. I am not able to say what a fair priced market CAPE is today. What I can say is that the 100 year CAPE average of 16.5 tells us nothing.
I offer a few other general observations about long term trends.
>Globalization and technology are causing companies earnings as a share of the GDP pie to increase vis a vis worker earnings; Impact on p/es?
>Profits, cash flow and return on capital have been increasing over the last 30 years and when this is combined with data on consolidation it shows that competition is lessening especially in concentrated and oligopolistic sectors: Impact on p/es?
>In the last twenty years there has been a significant corporate margin expansion. Most of this margin expansion seems to have come from two factors: the increased proportion of foreign profits, which had higher margins because of lower corporate tax rates; and the increased weight of the technology sector in the S&P 500 index, a sector that usually carries the highest profit margins. Reversion? Impact on p/es?
>Corporate tax rates have been lowered in the U.S; Impact on p/es?
>The strength of corporate balance sheets – cash holdings vs debt have changed substantially over the decades; Impact on p/es?
>Corporate dividend and share buyback policies change substantially over the decades; Impact on p/es?
These various factors have differing potential impacts on the appropriate level of price earnings ratios in the stock market. Some may tend to increase price earnings ratios, some may tend to decrease price earnings ratios.
Professor Shiller is alive to some of these issues. In an article titled: The World’s Priciest Stock Market published Jan 23, 2018 he wrote:
“Part of the reason for America’s world-beating CAPE ratio may be its higher rate of share repurchases, though share repurchases have become a global phenomenon. Higher CAPE ratios in the US may also reflect a stronger psychology of fear about the replacement of jobs by machines.
The flip side of that fear, as I argued in the third edition of my book Irrational Exuberance, is a stronger desire to own capital in a free-market country with an association with computers.
The truth is that it is impossible to pin down the full cause of the high price of the US stock market. The lack of any clear justification for its high CAPE ratio should remind all investors of the importance of diversification, and that the overall US stock market should not be given too much weight in a portfolio.”
Conclusion
I have pointed out that price earnings ratios may be high for a reason, not just because prices/values are too high. For all the above reasons I am not comfortable using CAPE as a tool to help me decide whether the “level of stock prices appears less or more attractive by value standards” to quote Ben Graham.
This post is the third of three posts about CAPE. Here are the other two: Problems with CAPE – Part l and Problems with CAPE – Part ll
For readers wanting to dig deeper into the subject of how to allocate amongst different asset classes based on whether the market is cheap or expensive, take a look at Part 5: Asset Management.
In particular, see Chapter 28. Asset allocation.
And specifically to read further about CAPE see Sections:
28.04 Other approaches to varying stock/bond allocation – CAPE
28.06 Conclusion regarding CAPE
Finally, for readers who have the idea of using CAPE as a benchmark for individual stock valuation see Section 39.06 CAPE
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