The Bear Down the Road

Two speakers at the recent IMCA conference seem to be telling us that we are about to experience a bear market–using very different metrics.

The 2017 IMCA conference in the San Diego Convention Center is now over.  The roughly 1,500 investment professionals, advisors and regional and wirehouse brokers were treated to keynote sessions by Sherry Turkle of MIT on the power of conversation; Jonah Berger of the Wharton School on marketing yourself through ‘contagious ideas,’ Rama Foroohar of the Financial Times on the state of the world; James O’Shaughnessey on Factor Alpha and Smart Beta; Yale School of Management’s Toby Moskowitz on style and smart beta investing; and Michael Sandel of Harvard University in an ethics presentation that I’ll review in the future.

But to me, the most interesting presentations gave a strong hint that we may be approaching a market top in U.S. equities—and, in fact, we may actually be in a bear market already.

Most of you know University of Chicago professor Dick Thaler as one of the founders of the behavioral finance research effort, perhaps also as author of The Winner’s Curse and Misbehaving: The Making of Behavioral Economics.  (He’s also co-author of Nudge.)  In his IMCA keynote address, Thaler talked about exactly what you’d expect: the limitations of the Efficient Market Hypothesis and the problems with building theories on what he called homo economus.  He made the case that certain market behaviors cannot be explained rationally, and that, despite all the academic assumptions, different people will inevitably respond very differently to the same stimuli, market or otherwise. 

Thaler compared himself, somewhat unfavorably, to fellow U. of Chicago professor Eugene Fama, who apparently behaves far more logically, optimizes his choices more effectively and happens to be a more focused golfer.  Later, he compared himself unfavorably to Mahatma Gandhi.  The point: not everybody optimizes their outcomes, or even understands what those words mean.

Later in the talk, almost as an aside, Thaler told us about a thought experiment that he developed in the late 1990s, during (some of you may remember) a raging bull market that seemed to many advisors to have reached a point of frenzy.  It was not a complicated experiment: at some point during his speeches to professional investors, Thaler would pose the following questions:

Suppose you had a $1,000 portfolio, today, that is equally invested in five prominent stocks.

1) What do you think is the intrinsic value of this portfolio?

2) How do you expect this portfolio to perform over the next six months?

In the late 1990s, the median answers, Thaler told the audience, were somewhat contradictory and certainly irrational: $500 (meaning the portfolio was 2X overvalued) and 20% (meaning the professionals expected the stocks to go up dramatically beyond their already over-valued state). 

Roughly translated, Thaler said, the median professional investor was relying on the “greater fool theory” of investing.

That was pretty dramatic.  But the punchline came later.  Thaler said that he has been asking these same questions several times a year ever since, and he showed us a chart with the results. 

Thaler-Slide-OneThe chart (see left) generally shows how investors estimated the value of stocks (red line) and how they expected the stocks to perform in the subsequent six months (black line).  Then he tracked the disparity between the two (gold line at bottom).  When the gold line was at or near zero, investors were demonstrating rational expectations of value and expected return; that is, if they said that stocks were fairly valued, then they expected little future return, and if they thought stocks were over- or under-valued, they adjusted their future return predictions accordingly. 

However, whenever the disparity line rose higher, where people considered stocks to be overvalued and also expected high future returns, it might be considered a leading indicator of when investors have lost their sense of perspective about the markets.  Whenever the gold line climbs upward, it is perhaps a hint that a period of irrationality is reaching a (bearish) culmination.

As the reader can see from the graph above, and which Thaler pointed out to the IMCA audience, the gold “exuberance line” is currently pertty high.  In fact, it is much higher than it was right before the 2000 downturn.

Yikes!

P/E Focus

To gain additional perspective, let’s turn to an IMCA conference breakout presentation by Ed Easterling, of Crestmond Research, author of Probable Outcomes and Unexpected Returns: Understanding Secular Stock Market Cycles. 

In his presentation, Easterling made the point, which I’m sure you’ve heard before, that stock market returns are driven by three, and only three, factors:

1) the growth in the earnings of a company;

2) the company’s dividend yield, and

3) the change in the P/E of the company—that is, whether people at the end of the investment horizon will pay more or less for a dollar of company earnings. 

Easterling-Slide-OneThe aggregate of these factors for groups of companies are what drives the growth or decline of indices.

Easterling showed the audience a chart which clearly demonstrates that the growth of aggregate corporate earnings tends to pretty closely track the growth of the economy as a whole, with some fluctuation above and below, but always returning to the GDP growth line. 

Meanwhile, dividend yield tends to closely track whatever the starting point is.  That is, aggregate changes in dividend yield are usually incremental, so your starting point is a pretty good estimate for the next ten years—and ten year periods, Easterling said, counts as the “long” time horizon for most investors.

Easterling-Slide-TwoThe third factor, the change in P/E ratios, is what defines bulls and bears.  In another interesting slide, Easterling showed 10-year rolling returns in the S&P 500 since 1900, broken out by each of the components: the earnings per share growth in blue, the dividend yield component in brown, and the P/E increases (green) and decreases (red).  It takes about two seconds to see that although there were fluctuations in the dividend yield and earnings growth over time, the P/E component is by far the primary driver determining whether the markets are bullish or bearish.  And, interestingly, the bulls and bears have been relatively cyclical; that is, if you just look at the peaks and troughs, the graph  (driven by investor sentiment, reflected in changes in P/E) kind of takes on the steadiness of a heartbeat.

But here’s the shocker: Easterling showed us a slide, with little commentary, which suggests that the U.S. stock market has been essentially bearish since 2000—something that might come as a surprise to anyone who has experienced the long, remarkably steady annual returns since March of 2009. 

Easterling-Slide-threeThe slide breaks out bull (green) and bear (red) markets, and if you just look at the top line of this exponential graph, you might wonder why the second half (or so) of the last red block isn’t green, since the markets have clearly risen, since first quarter 2009, at least as steeply as some of the bull markets. 

The answer is in the bottom part of that same graph, which provides Easterling’s definition of a bear market—a decline in the P/E ratio.  Since 2000, the P/E ratio has experienced a long, very slow decline with no obvious termination.

How does Easterling expect our current bear market to end?  Toward the end Easterling-Slide-Fourof his presentation, he showed a slide (left) that charts previous bear markets, graphed not as the usual steep decline in market prices. 

Instead, this graph illustrates each bear market’s decline in P/E from peak to trough.  You can see that the 1966-1981 (orange line) bear started at a P/E of around 25 and ended somewhere around 8.  The others were all pretty consistent, beginning somewhere in the 20s and ending with a P/E somewhere below 10—except the current period starting in 2000, which began at P/E 46 or so and has never gotten below 15 even in the depths of the 2008-9 collapse. 

What does this mean?  If you think, as Easterling does, that this bear won’t be officially over until the P/E drops down into single digits, then the picture going forward is not optimistic.  The endpoint for the market is not a market top, but a continuing decline in P/E until we finally hit—what?  Seven?  Eight?  Whatever that is, it will be a significant drop from where we are today.

When I took a second look at that final graph, it occurred to me that even if you agree that bear markets are defined by declining P/Es, you could decide that the decline starting in 2000 was an anomaly, because it originated at almost twice the valuation of prior bears.  Therefore, the P/E drop to around 15 completes the bear market cycle, and the rise from a P/E of 15 to the current 27 or so represents a new bull market.

But even if you adopt that interpretation, you also notice that current P/E valuations are higher than the starting point of any of the previous modern day bear markets.  Just like Thaler’s graph, you feel like you’re staring at the evidence for a steep decline—time and date unknown, but seemingly inevitable.

Unlike Thaler, Easterling took a stab at outlining the possibilities for the next 10 years by looking at two scenarios: one with low inflation (and therefore, by his calculation, no change in P/E from current levels) or average inflation. 

His bottom line is that a low inflation scenario would see earnings grow at a 3.56% annual rate, with 2% dividends and no change in the P/E. 

The average inflation scenario would see higher earnings growth of 5.06% (which happens to be exactly the average from 1926-2015), coupled with the same 2% dividend, but a six percent drop in the P/E.

Bottom line: if inflation stays low, Easterling said that this would imply a 5.56% all-in return on your stock market holdings over the next 10 years.  If inflation rises to average levels (3%), then we could be looking at 1.06% average annual returns for the coming decade.

And even that decrease in the P/E wouldn’t take the markets down to what Easterling seems to believe is the termination point of this bear market. 

Yikes!