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The Uncertainty Principle – Kicking the Tyres of our Investment Views

We think many equity markets are fully or over-valued. 

That’s all very well but how can we be so certain?  Have we made a mistake, are we sure? These are very worthy questions that we constantly ask ourselves and although we undergo this ‘tyre-kicking’ exercise as a matter of course, we thought it may be useful to share some of the tests we apply.

If In Doubt, Invert 

We assume we are wrong. 

Much has been written over the last decade, especially since the credit crisis, about the behavioural pitfalls of having human brains making investment decisions.  Traits such as ‘confirmation bias’ lead the brain to convince itself that its initial conclusion is right, even if there is subsequent directly contradictory evidence. 

At least by starting with the premise we are wrong, then we have eliminated the primal drive to try and prove we are always right.

Buy, not sell?

OK, going back to investing, instead of being overvalued, how could the stock market be cheap now? 

One of the key arguments on the markets is the valuation.  Our data suggests that one of the most overvalued markets is the US stock market. 

We use a number of valuation metrics but take, for instance, the price to earnings multiple on the US stock market for the year ahead (markets are all about future earnings) of around 17.8x.  This is substantially above the long term average of around 14x and, given the outlook, we see little scope for this to be improved with better corporate earnings than currently expected.

How could we be wrong? Let’s look at four mis-calculations we may have made…

a) The Trump Tax Taper?

First off, if US corporate profits come in better than these expectations, the market may be cheaper than we think and we run the risk of missing out on potential good returns.  One very tangible reason why profits may be higher is if President Trump goes ahead with his proposals to reduce the corporate tax rate from 35% to 25% or even 15%.

Let’s just look at this.  The forward price/earnings multiple is derived from the current S&P Index level of 2400 divided by the forecast earnings per share of all the companies in the Index of around $135 (2400/135 = 17.8x).  If Trump is successful in getting the policy approved it is generally accepted that for every 1% of tax cut this would add about $1.30 per share to earnings.  Using this, we can map out what the valuation would be under various scenarios:-

Tax Rate 35% (current)        25%             15%      
Earnings per share $135  $148

$161

P/E 17.8x 16.2x 14.9x

 

Thus, assuming the best case scenario of 15% and assuming no tax cuts are in any earnings forecasts for 2018, then the valuation of the market is still above long term averages - although at 14.9x admittedly lower than the 17.8x we believe it to be.  

b)  The Debt Factor?

If you run a company that has no borrowings and want to expand, taking on higher debt makes sense.  Higher debt (within limits) lowers the overall cost of capital for the company, especially given the exceptionally low interest rates that banks currently charge.  Thus, if the company could invest the amount raised from the loan and achieve a rate of return above the (very low) cost of the debt, this would raise the company’s earnings.

What is true for a company is also true in aggregate for the Index.  Earnings can be enhanced by greater debt, thus making the underlying valuation more attractive than the headline figure.  Conversely, cash holdings currently return very little and act as a drag on earnings. 

Corporate analyst Aswath Damodaran* looked at the historic effect of this on the US stock market to investigate the impact on the valuation.

Below is the chart of the findings. The purple line shows the price/earnings valuation based on the ‘conventional’ earnings figures and the blue line shows the non-cash valuation taking into consideration the level of debt:-

graph1.png

Source: aswathdamodaran.blogspot.co.uk

As can be seen, the blue line that takes account of the greater debt (and interest rates) is indeed lower than the conventionally-calculated price/earnings valuation shown in purple. 

That said, although this chart finishes in 2014, the debt-adjusted valuation was still well above the long-term non-cash average p/e of 11x and since 2014 the Index has risen by about 17%, whilst earnings have risen by around 10% (as taken from Reuters) resulting in an even higher valuation today.

c) A New Paradigm?

Of course, we might be missing the big picture too.  Individual country or global growth could be much higher than currently expected. 

The investment bank, JP Morgan, recently produced the chart below illustrating the key drivers to economic growth in the US over the last fifty years.  

graph2.png

Source: JPMorgan, Guide to the Markets, UK, Q1 2017

Demographics plays a key role in growth and because of its predictable nature we know that over the next ten years this is due to grow by 0.4%, the same rate as the last decade. 

That leaves growth in real output per worker, or productivity growth, as the largest component of future economic growth.

Technology may be the key here.  Artificial intelligence, the internet of everything and robotics (and many technologies that we may not even be aware of today) could serve to raise this figure - this steps in the realm of the unknown and we acknowledge it could be a piece of the jigsaw we are missing. 

What we can do is look back at the ‘Internet Age’ of 1997 to 2007, and see the pick-up in productivity to 1.9% per annum - if we apply this to the 0.4% forecasted growth in working population then that only gets us to 2.4%, certainly an improvement (but still below long term historic growth rates). 

d) Lower for Longer?

One further way we could be wrong is if interest rates stay as low as they are now (or lower) deep into the future, or forever. 

In theory, stock market valuations should amount to the total cash flows in the future discounted back at a discount rate.  The discount rate is dependent on the risk-free rate, or central bank’s base rates, and therefore the lower they are likely to be and the longer they remain there, (given the inverse relationship as the denominator), the higher the value of the market should be.

In simpler terms, compared to an interest rate of 0.7%, almost any investment looks cheap and it is no wonder investors would continue to buy shares, pushing the index even higher.

A counter to this point is that if interest rates are so low for so long, this implies something seriously weak for long term economic growth or a cataclysmic policy error on the part of central bankers.

Our Rational Approach

We take this very seriously. 

In investment markets, calling investment timing or levels is difficult but judging both is a very rare talent. Calling it wrong can be very costly.

JP Morgan recently ran the numbers and found that if an investor sold all their US shares 12 months too early of market peaks, they would have forgone returns, on average, of 27%, and calling it two years too early would mean missing out on an average of 39% returns. 

Serious numbers indeed. 

We are not arrogant enough to believe we have that rare talent to call the top of the market in both level and timing.  However, what we do know is that, over time, the higher the valuation of an asset the lower the subsequent returns.  In this light, instead of putting all our chips on black or red, we have been incrementally reducing client portfolio holdings in some equities as valuations have pushed up to historically high levels.

Hopefully this has shown that this is not the result of a rash or opinionated view but a calm and logical approach to investing that has been shown to serve our clients well over many market cycles.

 

The information provided through the Equilibrium website is based on our opinion and is for general information purposes only. It is not, and should not be construed as financial advice.

*http://aswathdamodaran.blogspot.co.uk/2015/06/debt-cash-and-pe-why-cash-is-upper-and.html