Is The Market Fundamentally Overpriced? Presenter: LARRY SWEDROE Buckingham

Transcription

1 Is The Market Fundamentally Overpriced? Presenter: LARRY SWEDROE Buckingham

2 Cape 10: Signaling the Market is Vastly Overvalued? Larry Swedroe Director of Research, The BAM ALLIANCE 2

3 The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts. Bertrand Russell Source: InfoWorld, Volume 23, Number 4, IS Survival Guide by Bob Lewis, (Epigraph of article), quote page 42, Column 1, Published by InforWorld Media Group.. 3

4 01/11/16 Source: MEAN

5 February 2012 CAPE 10 at 21.8 Mid-November 2013 CAPE 10 at 24.6 March 2014 CAPE 10 at 25.0 Over next seven years the return to S&P 500 is expected to be less than 1% p.a. in real terms and less than 3.5% in nominal terms. Jeremy Grantham S&P 500 is approximately 75% overvalued. Estimated real return to the S&P 500 of -1.3% per year for the next seven years. Jeremy Grantham Stocks 65% overpriced. Jeremy Grantham S&P % S&P % S&P % Source: Are Grantham and Hussman Correct About Valuations. Advisor Persepctives, June 16,

6 Six Issues Related to the CAPE Use of 135-year 10 and historical mean the ERP Changes in accounting rules Change in propensity to pay dividends Changes in the strength of corporate balance sheets Improvements in liquidity Financial innovation 6

7 Use of 135-Year Historical Mean CAPE 10 data goes back to 1870s Very different economic regimes that exist today For much of the period, no Federal Reserve, SEC nor FASB 7

8 Use of 135-Year Historical Mean Federal Reserve SEC FASB Created more stable economy/less economic volatility Provided greater protection for investors Created more transparency for investors 8

9 Which country has the highest cost of capital and thus, the highest expected return to U.S. providers of capital? Brazil Kazakhstan 9

10 Shiller CAPE 20 Historical Mean Since Since Since Since

11 Changes in Accounting Rules Pre-2001 FAS 142 and : FAS : FAS 144 GAAP required goodwill to be amortized over a 40-year period Requires annual test for impairment of goodwill and immediate appropriate write down. Impairment test applies to all intangible assets and all long-lived assets. 11

12 Change in Corporate Propensity to Pay Dividends Firms paying cash dividends fell from 67% in 1978 to 21% in Dividend payout ratio on the S&P 500 fell from average of 52% from 1954 through 1995 to an average of just 34% since. 12

13 Strength of Balance Sheet More (Cash cash on company s and Debt balance sheet Levels) decreases equity risks, Matters reducing the required ERP, raising the P/E. More debt increases equity risks, raising the required ERP, lowering the P/E. Low P/E ratio can be indicative of cheapness, but also result of high debt ratios and low cash holdings. High P/E ratio can point to over-priced stocks, but can be caused by high cash balances and low debt ratios. 13

14 How Do Today s Cash and Debt Levels Cash holdings at non-financial service companies in the U.S. 7.30% versus median of 7.23% from 1962 to Compare to Historical Averages? Total debt was 24.2% of value versus the median from 1962 to 2014 of 28.4%. 14

15 Improvements in Liquidity Investors demand a risk premium to hold less-liquid assets. The cost of liquidity, in the form of bid-offer spreads, has decreased. Decimalization of stock prices Provision of additional liquidity by high-frequency traders 15

16 Financial Innovation Low cost mutual funds and ETFs allow investors to buy and sell illiquid assets indirectly, with very low transactions costs. Reduced costs lower the sensitivity of returns to liquidity. 16

17 Is The Market Overvalued? Since 1960 mean CAPE 10 about 20 FAS 142 and 144: +4 Lower dividend payout rations: +1 Higher cash balances and lower debt levels: +? Lower trading costs: +? Financial innovation: +? Zero/negative real interest rates:? 17

18 Takeaways Given regime changes use of a 135-year average to determine if market is overvalued may be inappropriate, adjustments need to be made Even if markets are fairly valued, bear markets will occur if the economic and geopolitical news is worse than expected High valuations mean that expected returns are now lower than historical returns 18

19 Cape 10: Signaling the Market is Vastly Overvalued? Larry Swedroe Director of Research, The BAM ALLIANCE 19

20 The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts. Bertrand Russell Source: InfoWorld, Volume 23, Number 4, IS Survival Guide by Bob Lewis, (Epigraph of article), quote page 42, Column 1, Published by InforWorld Media Group.. 20

21 01/11/16 Source: MEAN

22 February 2012 CAPE 10 at 21.8 Mid-November 2013 CAPE 10 at 24.6 March 2014 CAPE 10 at 25.0 Over next seven years the return to S&P 500 is expected to be less than 1% p.a. in real terms and less than 3.5% in nominal terms. Jeremy Grantham S&P 500 is approximately 75% overvalued. Estimated real return to the S&P 500 of -1.3% per year for the next seven years. Jeremy Grantham Stocks 65% overpriced. Jeremy Grantham S&P % S&P % S&P % Source: Are Grantham and Hussman Correct About Valuations. Advisor Persepctives, June 16,

23 Six Issues Related to the CAPE 10 and the ERP Use of 135-year historical mean Changes in accounting rules Change in propensity to pay dividends Changes in the strength of corporate balance sheets Improvements in liquidity Financial innovation 23

24 Use of 135-Year Historical Mean CAPE 10 data goes back to 1870s Very different economic regimes that exist today For much of the period, no Federal Reserve, SEC nor FASB 24

25 Use of 135-Year Historical Mean Federal Reserve SEC FASB Created more stable economy/less economic volatility Provided greater protection for investors Created more transparency for investors 25

26 Which country has the highest cost of capital and thus, the highest expected return to providers of capital? U.S. Brazil Kazakhstan 26

27 Shiller CAPE 20 Historical Mean Since Since Since Since

28 Changes in Accounting Rules FAS 142 and 144 Pre-2001 GAAP required goodwill to be amortized over a 40-year period 2001: FAS 142 Requires annual test for impairment of goodwill and immediate appropriate write down. 2001: FAS 144 Impairment test applies to all intangible assets and all long-lived assets. 28

29 Change in Corporate Propensity to Pay Dividends Firms paying cash dividends fell from 67% in 1978 to 21% in Dividend payout ratio on the S&P 500 fell from average of 52% from 1954 through 1995 to an average of just 34% since. 29

30 Strength of Balance Sheet (Cash and Debt Levels) Matters More cash on company s balance sheet decreases equity risks, reducing the required ERP, raising the P/E. More debt increases equity risks, raising the required ERP, lowering the P/E. Low P/E ratio can be indicative of cheapness, but also result of high debt ratios and low cash holdings. High P/E ratio can point to over-priced stocks, but can be caused by high cash balances and low debt ratios. 30

31 How Do Today s Cash and Debt Levels Compare to Historical Averages? Cash holdings at non-financial service companies in the U.S. 7.30% versus median of 7.23% from 1962 to Total debt was 24.2% of value versus the median from 1962 to 2014 of 28.4%. 31

32 Improvements in Liquidity Investors demand a risk premium to hold less-liquid assets. The cost of liquidity, in the form of bid-offer spreads, has decreased. Decimalization of stock prices Provision of additional liquidity by high-frequency traders 32

33 Financial Innovation Low cost mutual funds and ETFs allow investors to buy and sell illiquid assets indirectly, with very low transactions costs. Reduced costs lower the sensitivity of returns to liquidity. 33

34 Is The Market Overvalued? Since 1960 mean CAPE 10 about 20 FAS 142 and 144: +4 Lower dividend payout rations: +1 Higher cash balances and lower debt levels: +? Lower trading costs: +? Financial innovation: +? Zero/negative real interest rates:? 34

35 Takeaways Given regime changes use of a 135-year average to determine if market is overvalued may be inappropriate, adjustments need to be made Even if markets are fairly valued, bear markets will occur if the economic and geopolitical news is worse than expected High valuations mean that expected returns are now lower than historical returns 35