It was Lao Tzu who stated several millenia ago that “those who have knowledge don’t predict and those who predict don’t have knowledge”, but nonetheless those that would have us believe they are the smartest minds in the market feel annually obliged to predict.
This year the average forecast from a group of 8 brokers for the FTSE 100 at year end 2012 is 5783 representing a gain of 3.8%. If those predicting such numbers don’t have knowledge and we know ourselves to be fools then perhaps we can’t do any worse by attempting to do some of the thinking ourselves. The goal of this article is to give a sweeping overview of the key drivers of share prices as understood by many of the best minds in finance and reflect on the optimal portfolio strategy for the prevailing environment.
There are four major influences on the direction of equity indices at any point in time, namely valuation, momentum, monetary and sentiment factors. While these factors may be argued over I would surmise that most additional factors (economy, earnings growth) can be bundled into one of these major categories.
Valuation- does it drive the Stock Market?
The conclusive evidence is that in the short term it doesn’t, but in the long term it does. The stock market has a tendency to gyrate over business cycles from excessive overpricing to excessive undervaluation. In order to find a value for the stock market, most investors start with the current and forecast PE ratio. Our calculations show that the median forecast PE Ratio of stocks in London stands at 13.8x with a dividend yield of 3.73% - near the long term historical norms and cheaper than the US. But profit margins are extremely high at present (at something like 9% in the US) which have historically always reverted to their long run averages - could the profits be at threat of a reversal making the PE higher than it looks? The current raft of earnings downgrades from brokers seems to back up this suspicion.
So if you can’t trust current earnings to value the market what do you do? One sage with an answer is Professor Robert Shiller, Yale Professor of Finance, who believes that using current earnings completely ignores the bigger picture of where we are in the business cycle. He calculates the current P/E ratio using 10 year average earnings in the denominator to smoothe out the peaks and troughs of recent business cycles. He calls it the Cyclically Adjusted PE Ratio, or the CAPE for short.
According to Shiller the US market is currently on a CAPE of 20.75, which is still 31% above its median value of 15.81 over the last 140 years. An overvaluation like this has the bears baying for blood as historically the CAPE has tended to mean revert and its been in a downtrend since 2000. It’s harder to find good data for the UK market, but Richard Beddard (blogger iii) has a back of an envelope version which gives the UK CAPE of 15x earnings - a lot higher than it was at the lows of 8 or 9 in early 2009 but not nearly as intimidating as the US data.
But there has been much argument in recent months in the US as to whether Shiller’s long term PE ratio should be relevant today given the extraordinary nature of the write-offs in the last decade due to several once in a lifetime bubbles. Merrill Lynch BofA equity strategist David Bianco argues that the CAPE should be adjusted to give a current PE of 12x compared with a long run average of 15x. Forecasting a rally in the S&P 500 to 1450 in 2012 in September lost him his job 3 days later, suggesting his bosses may have had a slightly more bearish views on the market or that (as conspiracy prone blog ZeroHedge alleges) the banks are colluding to flush out weak market hands before QE3 turns them a tidy profit through Q2 2012.
Tobin’s Q is another long term valuation tool that shows US non-financial shares overvalued by 26.5%. Tobins Q, popularised in 2000 for forecasting the dotcom demise, attempts to compare the market value of companies with their replacement cost and it correlates very closely with CAPE over the long term. But again it too has its critics who state that it’s out of date given that market valuations are nowadays far more dependent on earning power than asset values and that Q ignores intangible assets such as brand values which aren’t on many balance sheets.
So now that we’ve had a look at PE ratios and asset valuations, lets look at dividends. Given the payout ratio for many UK companies is low at present many analysts believe that there ought to be room for dividends to grow in coming years. At an average yield of 3.7% most equities are paying a lot more than savers get in the bank which should provide support for shares.
An excellent book landed on my desk before Christmas called How to Value Shares and Outperform the Market by former Cazenove banker Glenn Martin. Martin takes a swing at most investing ratios like the PE as they completely ignore the prevailing economic environment. Martin rationally sets about showing how investors can create a valuation spreadsheet for the FTSE 100 incorporating the current price and yield of the FTSE and the current level of inflation and interest rates. By using the historical norm of a 2% real annual dividend growth rate the system suggests that the FTSE is 43% undervalued while using this system in reverse suggests that the market is currently expecting dividends to decline by 3.5% per year for 5 years which would be the * worst 5 year decline since 1980* - are things really that bad? Even my ‘disaster scenario’ using the system which anticipated a spike in inflation and rates and a crashing dividend payout only suggested a 10% fall for the FTSE suggesting that there’s not too much downside by these metrics. Martin’s system has a pretty good track record over the last 20 years but its dependence on the difference between bond and dividend yields reminded me of the much maligned Fed Model which was popularised during the Greenspan years.
Don’t fight the Fed?
The much derided Alan Greenspan swore by his Fed Model equity valuation technique which stated that shares were cheap when the earnings yield of equities exceeded the 10 Year Treasury Bond Yield. Currently the earnings yield far exceeds bond yields by the greatest amount since the 1950s suggesting (according this model) that investors ought to be flocking into equities - after all, if you can get a far higher return by investing in equities than in bonds without too much added risk then slowly funds ought to be reallocated back to the stock market - right? So why aren’t they? Either investors expect that rates are going to spike - which interest rate curves deny - or that investors expect earnings to collapse which is more likely. While the Fed Model did work from the late fifties until 1997, both before and since the relationship has broken down, resulting in Andrew Smithers (of Tobins Q fame) calling Greenspan’s use of the Fed Model ‘an egregious use of data mining’. Perhaps it could it be that Glenn Martin’s optimistic dividend based approach suffers from the same problem?
Martin Zweig, the US quant investor, always had a great following in the 1980s and 1990s with a rally cry of ‘Don’t fight the Fed and Don’t fight the Tape’. He built a model that had investors buy into the stock market on dips in interest rates and get out on rises. The Greenspan put (dropping interest rates on equity market declines) further conditioned equity investors to ‘buy every dip’ for 20 years and contributed to millions of lemmings first making fortunes then losing them again in the dot com bubble precipice. But rates can’t go any lower from here. They hover near zero both in the UK and US leaving no leverage for rate dip junkies.
But Helicopter Ben Bernanke has of course come to the rescue of nervous equity investors in recent years by turning on the printing press (a process more euphemistically known as quantitative easing (QE)) . The last round of QE in 2010 launched a 30% market rally and many market insiders are expecting a similar boost from a further QE3 announcement early this year. Certainly, any more deterioration in the Eurozone would make this a near certainty leading to either a minimisation of equity downside risk or a big rally in equities if macro-economic worries stabilised. The potential of QE3 is certainly another feather in the cap of the bulls.
It’s grim out there… can sentiment possible be worse?
A good friend of mine whose opinion I value dearly thinks that all historic stock market techniques are out of the window in this environment of economic disaster with bulls and PIIGS lined up for slaughter by a slowly wielding macro axe. But I’m someone who plugs his ears to stories in memory of Odysseus - its more likely the Sirens that will lead you into the rocks than the cartographers. Macro stories are hard to quantify and making judgements based on qualitative information has been shown time and time again to lead to the poor decision making.
So what can we quantify? Sentiment for one. The best in the business is Investors Intelligence who have charted investment advisor sentiment for decades. The latest public reading of -12% is deep in the negative at its lowest level since 2009 with bearish advisors greatly exceeding bullish advisors in number. Extreme readings such as these have been shown to be reliable contrary indicators for the stock market: ’ the major rallies of the last decade have all started during periods of severely depressed investor sentiment.’.
And what of other behavioural factors? Jeremy Grantham of GMO is one of the finest market minds of recent decades and his quarterly investment letters are required reading. In his latest he discusses GMO research into what explains, but doesn’t predict, the PE Ratio. The two greatest explanatory factors for PE Ratios were found to be profit margins and inflation. Our current environment has high margins and very low inflation. In such an environment the paper suggests historically that stock markets tend to be priced in the top 5% of valuations. It should be noted that Grantham is very much a long term bear, but understands that the pull of these 2 factors give investors ‘comfort’ against the massive gravitational pull of the extremely negative macro environment. Behaviourally he suggests we could see a market rally 20% higher than its current level, whereas longer term value (given the CAPE, Tobins Q etc) points to a level far lower. Grantham preaches caution in this equity market.
The trend is your friend… or don’t fight the tape.
Furthermore in our detective tale lets look at the state of a few major technical factors and where they stand in the debate. Technical analysis without recourse to fundamentals for longer term predictions is never a wise idea as it can lead to over-optimistic forecasts (such as FTSE 10,000 by end 2012) but over the short term it can regularly turning points. In my experience, which doesn’t include much tea leaf reading, there’s only a few that have ever had much predictive value in the short to medium term, the best of which is the Coppock.
The Coppock Indicator was developed by Edwin Coppock and first published in 1962. He thought that market downturns required a period of mourning and discovered that most bereavement cycles lasted 11 to 14 months which were the periods he decided to use in his indicator. The Coppock curve has a phenomenal track record of highlighting the start of bull markets, but as a sell indicator it has a more checkered history. The state of the Coppock for most equity markets is currently a ‘wait’ after sell indicators in 2010 and it may take some time for a bull signal to be flagged again. More interestingly though both Dominic Picarda of the Investors Chronicle and Albert Edwards (Soc Gen Permabear) have written that the Coppock has signalled a ‘Killer Wave’ - effectively a double top of two sell signals in succession. Picarda ’ has identified eight killer waves in the S&P 500 over the last 83 years. All have been followed by substantial losses. The average fall following a killer wave has been 40 per cent over 20 months.’
Many technicians swear by other indicators - the 4% rule, Dow Theory, Bull Market Age, the VIX, Market breadth and so on - but all or most seem to be giving mixed signals at this current moment in time. The markets have been very volatile of late and the prevalence of false momentum signals has damaged the performance many of the best trend following/quant hedge funds. I’d be interested to hear from technicians in the comments below of anything that we should all be aware of.
As Lao Tzu would say “Stop thinking, and end your problems“…
So in our stroll through valuation, monetary, sentiment and momentum factors we have discovered much to argue over. Sensible valuation techniques seem to show the UK and US stock markets anywhere from 35% over valued to a similar amount undervalued, Technical indicators suggest the extreme possibility of a 40% decline, Sentiment and behavioural factors hint at a chance of a 20% rally while monetary factors seem to also suggest a 20% support rally waits in the wings.
In weighing up these factors I would suggest that the picture is delicately balanced with the bear side outweighing the bulls in the medium term but with the short term likelihood of the rally from the lows continuing on QE3 and sentiment relief factors. Certainly there doesn’t seem to be any margin of safety built into current prices and instability rules suggesting that range traders may finally win out. Sensible buy and hold investors might want to wait for a rout on the market to swing the edge back to the long only side , but if that doesn’t come to pass the stage is set for fleet footed long/short stock pickers to outperform.
What are your thoughts on the state of the market?