Wednesday, July 07, 2004

The Place of No Returns

July 7, 2004 - Street Insight

  • For the next decade the sign on the door of index funds should read: "A place of low fees and no returns."
  • The future is in the hands of the active managers, not the indices.
  • Broad stock market returns will be flat, at best, for some time.

We expect the stock market to remain essentially flat for years to come. The 12.8% compound return the market has enjoyed 1982 is over. As Yogi Berra warns, "The future ain't what it used to be."

Higher market returns over the past two decades have been driven largely by P/E expansion. Rising interest rates mean we're facing a P/E contraction. We expect the shrinking of P/Es to offset earnings gains and keep the market flat until valuations become much more attractive. To be precise, price appreciation contributed 10.3% of the 12.8% compound return on the S&P 500. (The other 2.5% came from dividends.) This 10.3% price appreciation in stocks was driven by two factors: earnings growth and P/E expansion. Earnings growth was around 6.1%, a very stable number that is in line with historical figures. P/E expansion averaged about 3.9% a year. That brought the trailing P/E on the S&P 500 from around 10 at the end 1982 to 24 today. One may argue that the "E" (earnings) component of the current P/E ratio is too low because the economy is coming out from the recession and thus the trailing P/E is overstated. To address this, we can look at ten-year trailing P/Es. That "normalizes" the P/E and encapsulates earnings over the total economic cycle. Only twice in modern history has the ten-year trailing P/E been higher for US stocks: before the Great Depression and at the height of the recent bubble. John Bollinger observed at the recent CFA Institute Conference that during the 20th century, a 16-year bull market was always followed by a 16-year bear market. In addition, every long-term flat market has developed when the Dow Jones hit a "1." The 1934-1950 market fluctuated around Dow 100. The 1966-1982 Dow struggled around the 1,000 mark. Those may not be full-fledged bear markets, but they certainly qualify as cubs. The most recent "cub" market started when Dow hit 10,000. Returns have been flat since. If history repeats itself, ten more years of flat returns are ahead of us. Payback Time The above-average growth the stock market has experienced since 1982 has come at the expense of future growth because it was driven largely by P/E expansion. Growth that is driven by P/E expansion borrows from the future because there is a limit to how far P/Es can expand. That future is now, and it is time to pay back. The historical average P/E of the market is about 15-17. If earnings continue to grow 6% a year (a reasonable assumption, consistent with past performance and future estimates), it would take six years of flat returns to bring the market P/E back to 17 times earnings. It would take eight years to bring it to 15 times earnings. The stock market is a strange fellow: It has multiple personalities. One personality is an extreme state of happiness, but the other suffers from strong depression. Rarely do these two personalities come to the surface at once. Usually one personality dominates the other for a long time. In the very long run these personalities cancel each other out, so "on average" the stock market is a rational fellow. But rarely does the stock market behave in an "average" manner. Most of the time the P/E of the stock market has been either much higher or much lower than average. The market has traded at 16-18 times earnings less than 20% of the time. In July of 1982 at the end of a major bear market, stocks were trading at only 7.4 times earnings. That was the time the depressed personality was at its peak. It is unlikely the happy personality will show up in time to save us from the depressed one. It rarely does. Markets overshoot. Thus it is very likely the current cub market will last longer than six or eight years and we will see P/E's much lower than 15. The Game Plan

  • We're in the "War of Rising of Earnings and Declining P/Es."
  • Sounds like a Schwarzenegger movie, doesn't it?
  • Here's our plan of attack.

We expect the coming cub market to be characterized by a positive economic environment with rising earnings offset by declining valuations. This is an environment in which stock selection becomes crucial.

The right tools Such a cub market requires a slight tune-up of analytical tools. Relative valuation analysis should be used very carefully and approached with a grain of salt. Relative valuations rely on the valuations of the last bull market. Those can be very different from the valuations that will be observed in the near future. Absolute valuation models serve as a better tool for stock valuation since they don't suffer from this benchmarking error. Discipline No-return markets are not calm. They exhibit very high volatility and have small bull and bear markets inside them. Volatility is likely to intensify with the elevated level of emotions that oscillating markets create. Improved liquidity and access in international markets is another reason why the volatility of the US market is likely to intensify. Dissatisfaction with US market returns will push investors to look for returns somewhere else. Adherence to a strict buy and sell discipline will help an investor take advantage of this volatility. Most common explanations used to justify high P/Es are based on "this time is different." It never is. Explanations are different every time but human behavior is not. As long as P/Es are dramatically higher than the historical average, an investor needs to check emotions at the door and follow a strict buy and sell discipline. Value is the name of the game An environment of rising interest rates will be devastating to growth stocks. Value stocks are a safer haven. Opportunistic approach In a raging bull market cash is any investor's biggest enemy because that boat doesn't rise with the tide. In oscillating markets cash should become a byproduct of one's investment discipline. If you can't find good companies to own at the right price, cash is a good alternative until a new opportunity presents itself. Dividend yield Dividend yield accounted for most of the total return during the bear market of 1966-1982. Dividends are likely to be a large portion of total return in the future as well. Dividend payout ratios for US companies are still below their historical average. Many companies would be able to raise payout ratios to 50% without hindering their growth prospects. Finance theory says a higher dividend payout ratio leads to a lower earnings growth rate. That sounds logical, but it doesn't work in practice. In reality, a higher dividend payout forces management to be more efficient. Larger dividend payouts limit managers' ability to throw money away at fruitless assets. Studies have shown that higher dividend payouts lead to higher earnings growth. So much for theory. The new dividend tax law and shareholder frustration with sub-par stock performance should create considerable pressure on management to raise dividends. We expect payout ratios to rise over time. The current earnings yield of S&P is around 4.3%. A dividend payout of 50% would create a dividend yield of 2.15% (at current prices), a considerable improvement from current yield of 1.4%. As the stock market grows into its earnings, dividend yields will rise. We're looking for stocks that generate significant free cash flow, since these cash flows are likely to be used to pay higher dividends or buy back stock.

Copyright 2004