Picture: 123RF/serezniy
Picture: 123RF/serezniy

When equity markets seem unstoppable, rising relentlessly on good, bad or no news, investors slowly forget what equity prices should represent. When markets have seemed quasi-invincible for more than 10 years, with every decline recouped extremely rapidly, thinking about what equity prices represent can be more a liability than an asset. “Buy the dips” works so well it is easy to build a narrative about it. But is it different this time?

Bubbles need leverage to develop. Rates below a certain level could have a detrimental effect on the real economy as investment in new productive capital becomes less elastic and rates decline on their way to 0%. Zombie companies survive, preventing “Schumpeterian” creative destruction and leaving excess supply in place, pushing inflation down and meaning savers have to spend less as their capital returns decline. The only thing thriving is finance, where actors put on more and more leverage to buy existing capital, through buybacks and M&A.

The consequence is increased debt unbacked by new productive capital, a system in which overall debt cannot be repaid, ever; a system in which the can is kicked down the road until it can’t any more. Dogmatic central banks have enabled all of this.

The end game is either an inflationary burst to save debtors, a multidecade slow growth environment, or a deflationary bust. Given that the debtors are governments, interest groups lobbying them and Generation X and the younger ones (who will soon dominate the electorate), we have little doubt that the inflationary scenario is the most probable.

Stocks are a claim on future cash flows. To assess their value nowadays we have to calculate their present value using an appropriate discount rate. At a given discount rate, the short-term fluctuations of cash flows have very little influence on market intrinsic value. Remove entirely one or two years of cash flow and the difference will be small. Changing the discount rate, on the other hand, can have a huge impact.

If we construct a historical corridor with boundaries between the 0% and 50% percentiles of Mape history the prospects look grim for buy-and-holders

Discount rate assumptions backed by market participants are strongly correlated with their mood. Bullish participants will accept a lower discount rate, all other things being equal. Prevailing interest rates usually serve as a loose anchor to discount rate assumptions. We can nevertheless see, experimentally, an increased exposure to risky assets the lower the risk-free rate is, even when the mean excess return is the same (see C Lian, Y Ma and C Wang, “Low interest rates and risk taking: Evidence from individual investment decisions”).

The current environment of extreme bullishness combined with a low (0%) short-term rate is an explosive combination — so explosive that the US S&P 500 is the most overvalued it has ever been. We demonstrate this using a methodology proposed by John Hussman, the margin-adjusted cyclically adjusted price earning ratio (Mape). Robert Shiller proposed the concept of cyclically adjusted price earning (Cape) to forecast seven to 12 years’ markets future returns using a long moving average of earnings. The goal was to smooth out the business cycle influence on earnings to get a smoother series called trend earnings.

The Cape model was good at forecasting forward return in the past, but some argue that accounting changes, payout policies and a move towards less competitive markets could have made the Cape model lose some or even most of its forecasting ability. Shiller therefore introduced the cyclically adjusted total return price earning ratio to account for the change in companies’ payout policies.

The following flaws remain:

  • One can get an even smoother trend earning series by adjusting the Cape to get constant historical margins. We use a 5.4% margin as the average (the Hussman assumption).
  • Margins could have increased permanently due to structural change. While this might explain some of the excess margins, we are convinced that a large part of the increase is transitory and that once capitalism can work as it should it will evaporate.

We have assumed a permanent margin increase to 7%. Regarding the data, the Mape is the highest it has ever been, dwarfing the 2000 tech bubble. If we construct a historical corridor with boundaries between the 0% and 50% percentiles of Mape history, the prospects look grim for buy-and-holders.

If we assumed a return to the Mape lows or to the Mape 50% percentiles, with nominal trend earnings growing at their historical pace and the current 2% dividend yield, one can see that the S&P 500 total return nominal compound annual growth rate to January 2030 would be -6.27%-1.68%.

A factor that could have a large influence on nominal returns is inflation. The tables (first if we are at 0% percentile in 2030, second at 50%) indicate the S&P 500 total return until January 2030 with various forward nominal earning growth and margins combinations.

One has also to be aware that the price investors are ready to pay for each unit of earning does not have a linear relationship with inflation. Equity market participants like moderate to low, steady inflation. High inflation or deflation have historically led to contracting Mape.

Markets are way overvalued and inflation will need to be historically high for investors to get positive nominal total return for the next 10 years.

• Cleusix is a director of Nava Capital SA.

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