A Riskier World?

This year’s Davos gathering is likely to be dominated by Donald Trump’s presence. I look forward to seeing him barge past other political and industry leaders to get his prime photo opportunity. As US equity markets continue to make all time highs in an unrelentingly fashion, it is scary to see the melt-up market been cheered on by the vivacious talking heads.

Ahead of Davos, the latest World Economic Forum report on global risks was released today. 59% of the contributors to the annual global risks survey point to an increase in risks in 2018, with environmental and cybersecurity risks continuing their trend of growing prominence, as can be seen below.

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Undoubtedly, environmental risks are the biggest generational challenge we face and it is hard to argue with the statement that “we have been pushing our planet to the brink and the damage is becoming increasingly clear“. That said, what is also striking about these assessments (and its important to remember that they are not predictions) is how the economic risks (light blue squares) have, in the opinion of the contributors, receded as top risks in recent years. The report does state that although the “headline economic indicators suggest the world is finally getting back on track after the global crisis that erupted 10 years ago” there is “continuing underlying concerns”.  Amongst these concerns, the report highlights “potentially unsustainable asset prices, with the world now eight years into a bull run; elevated indebtedness, particularly in China; and continuing strains in the global financial system”.

A short article in the report entitled “Cognitive Bias and Risk Management” by Michele Wucker caught my attention. The article included the following:

Risk management starts with identifying and estimating the probability and impact of a given threat. We can then decide whether a risk falls within our tolerance limits and how to react to reduce the risk or at least our exposure to it. Time and again, however, individuals and organizations stumble during this process—for example, failing to respond to obvious but neglected high-impact “grey rhino” risks while scrambling to identify “black swan” events that, by definition, are not predictable.

and

One of the most pervasive cognitive blinders is the availability bias, which leads decision-makers to rely on examples and evidence that come immediately to mind. This draws people’s attention to emotionally salient events ahead of objectively more likely and impactful events.

I do wonder about cognitive blinders and grey rhinos for the year ahead.

Keep on moving, 2018

As I re-read my eve of 2017 post, its clear that the trepidation coming into 2017, primarily caused by Brexit and Trump’s election, proved unfounded in the short term. In economic terms, stability proved to be the byword in 2017 in terms of inflation, monetary policy and economic growth, resulting in what the Financial Times are calling a “goldilocks year” for markets in 2017 with the S&P500 gaining an impressive 18%.

Politically, the madness that is British politics resulted in the June election result and the year ended in a classic European fudge of an agreement on the terms of the Brexit divorce, where everybody seemingly got what they wanted. My anxiety over the possibility of a European populist curveball in 2017 proved unfounded with Emmanuel Macron’s election. Indeed, Germany’s election result has proven a brake on any dramatic federalist push by Macron (again the goldilocks metaphor springs to mind).

My prediction that “volatility is likely to be ever present” in US markets as the “realities of governing and the limitations of Trump’s brusque approach becomes apparent” also proved to be misguided – the volatility part not the part about Trump’s brusque approach! According to the fact checkers, Trump made nearly 2,000 false or misleading claims in his first year, that’s an average of over 5 a day! Trump has claimed credit for the amazing performance of the 2017 equity market no less than 85 times (something that may well come back to bite him in the years ahead). The graph below does show the amazing smooth performance of the S&P500 in 2017 compared to historical analysts’ predictions at the beginning of the year (see this recent post on my views relating to the current valuation of the S&P500).

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As for the equity market in 2018, I can’t but help think that volatility will make a come-back in a big way. Looking at the near unanimous positive commentators’ predictions for the US equity market, I am struck by a passage from Andrew Lo’s excellent book “Adaptive Markets” (which I am currently reading) which states that “it seems risk-averse investors process the risk of monetary loss with the same circuit they contemplate viscerally disgusting things, while risk-seeking investors process their potential winnings with the same reward circuits used by drugs like cocaine”. Lo further opines that “if financial gain is associated with risky activities, a potentially devastating loop of positive feedback can emerge in the brain from a period of lucky investments”.

In a recent example of feeding the loop of positive feedback, Credit Suisse stated that “historically, strong returns tend to be followed by strong returns in the subsequent year”. Let’s party on! With a recent survey of retail investors in the US showing that over 50% are bullish and believe now is a good time to get into equities, it looks like now is a time where positive feedback should be restrained rather than being espoused, as Trump’s mistimed plutocratic policies are currently doing. Add in a new FED chair, Jay Powell, and the rotation of many in the FOMC in 2018 which could result in any restriction on the punch bowl getting a pass in the short term. Continuing the goldilocks theme feeding the loop, many commentators are currently predicting that the 10-year treasury yield wouldn’t even breach 3% in 2018! But hey, what do I know? This party will likely just keep on moving through 2018 before it comes to a messy end in 2019 or even 2020.

As my post proved last year, trying to predict the next 12 months is a mugs game. So eh, proving my mug credentials, here goes…

  • I am not even going to try to make any predictions about Trump (I’m not that big of a mug). If the Democrats can get their act together in 2018 and capitalize on Trump’s disapproval ratings with sensible policies and candidates, I think they should win back the House in the November mid-terms. But also gaining control of the Senate may be too big an ask, given the number of Trump strong-holds they’ll have to defend.
  • Will a Brexit deal, both the final divorce terms and an outline on trade terms, get the same fudge treatment by October in 2018? Or could it all fall apart with a Conservative implosion and another possible election in the UK? My guess is on the fudge, kicking the can down the transition road seems the best way out for all. I also don’t see a Prime Minster Corbyn, or a Prime Minister Johnson for that matter. In fact, I suspect this time next year Theresa May will still be the UK leader!
  • China will keep on growing (according to official figures anyway), both in economics terms and in global influence, and despite the IMF’s recent warning about a high probability of financial distress, will continue to massage their economy through choppy waters.
  • Despite a likely messy result in the Italian elections in March with the usual subsequent drawn out coalition drama, a return of Silvio Berlusconi on a bandwagon of populist right-wing policies to power is even too pythonesque for today’s reality (image both Trump and Berlusconi on the world stage!).
  • North Korea is the one that scares me the most, so I hope that the consensus that neither side will go there holds. The increasingly hawkish noises from the US security advisors is a worry.
  • Finally, as always, the winner of the World Cup in June will be ……. the bookies! Boom boom.

A happy and health New Year to all.

Happy Returns

A recently published paper, called “The Rate of Return on Everything, 1870–2015”, looks extremely interesting. The authors – Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor – have collected a unique dataset of total returns for equity, housing, bonds, and treasury bills covering 16 advanced economies from 1870 to 2015.

The paper calculates real returns across asset classes on a global GDP weighted basis, as per this graph.

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The paper contains some fascinating conclusions, such as housing and equities having similar returns but with housing being considerably less volatile, as per this graph.

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Another fascinating graph is on the risk premium between risky and safe assets, as below.

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Given the time of year, I haven’t had an opportunity to consider the paper in detail but will hopefully get a chance over the Christmas break (and now back to wrapping presents!!).

A very happy Christmas to all who spend any time here. Have a great time and I hope Santa is kind!

Aging Gracefully

The OECD had an interesting piece on old age dependency ratios across countries, predicting that on average they would nearly double over the next 35 years for the 20-64 cohort, as per the graph below.

click to enlargeOld Age Dependency Ratio

Japan and Spain come out the highest in the 2050 projection, followed by Greece, Portugal, Italy and Korea. Interestingly, the countries that came out the lowest in the 2050 projection were Australia, the US, Turkey, Mexico and Israel.

Broken Record

Whilst the equity market marches on regardless, hitting highs again today, writing about the never-ending debates over equity valuations makes one feel like a broken record at times. At its current value, I estimate the S&P500 has returned an annualised rate of nearly 11%, excluding dividends, since its low in March 2009. As of the end of September 2017, First Trust estimated the total return from the S&P500 at 18% since March 2009, as per the graph below.

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Goldman Sachs recently published an analysis on a portfolio of 60% in the S&P 500 and 40% in 10-year U.S. Treasuries, as per the graph below, and commented that “we are nearing the longest bull market for balanced equity/bond portfolios in over a century, boosted by a Goldilocks backdrop of strong growth without inflation”. They further stated that “it has seldom been the case that all assets are expensive at the same time—historical examples include the Roaring ‘20s and Golden ‘50s. While in the near term, growth might stay strong and valuations could pick up further, they should become a speed limit for returns”.

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My most recent post on the topic of US equity valuations in May looked at the bull and bear arguments on low interest rates and heighten profit margins by Jeremy Grantham and John Hussman. In that post I further highlighted some of the other factors which are part of the valuation debate such as the elevated corporate leverage levels, reduced capital expenditures, and increased financial risk taking as outlined in the April IMF Global Financial Stability report. I also highlighted, in my view, another influential factor related to aging populations, namely the higher level of risk assets in public pensions as the number of retired members increases.

In other posts, such as this one on the cyclically adjusted PE (CAPE or PE10), I have highlighted the debates around the use of historically applicable earnings data in the use of valuation metrics. Adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation) are just some examples of items to consider.

The FT’s John Authers provided an update in June on the debate between Robert Shiller and Jeremy Siegel over CAPE from a CFA conference earlier this year. Jeremy Siegel articulated his critique of the Shiller CAPE in this piece last year. In an article by Robert Shiller in September article, called “The coming bear market?”, he concluded that “the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets”.

The contribution of technology firms to the bull market, particularly the so-called FANG or FAANG stocks, has also been a much-debated issue of late. The graph below shows the historical sector breakdown of the S&P500 since 1995.

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A recent article from GMO called “FAANG SCHMAANG: Don’t Blame the Over-valuation of the S&P Solely on Information Technology” tried to quantify the impact that the shift in sector composition upon valuations and concluded that “today’s higher S&P 500 weight in the relatively expensive Information Technology sector is cause for some of its expensiveness, but it does not explain away the bulk of its high absolute and relative valuation level. No matter how you cut it, the S&P 500 (and most other markets for that matter) is expensive”. The graph below shows that they estimate the over-valuation of the S&P500, as at the end of September 2017, using their PE10 measure is only reduced from 46% to 39% if re-balanced to take account of today’s sector weightings.

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In his recent article this month, John Hussman (who meekly referred to “his incorrectly tagged reputation as a permabear”!!) stated that “there’s no need to take a hard-negative outlook here, but don’t allow impatience, fear of missing out, or the illusion of permanently rising stock prices to entice you into entrusting your financial future to the single most overvalued market extreme in history”.

As discussed in my May post, Hussman reiterated his counter-argument to Jeremy Grantham’s argument that structurally low interest rates, in the recent past and in the medium term, can justify a “this time it’s different” case. Hussman again states that “the extreme level of valuations cannot, in fact, be “justified” on the basis of depressed interest rates” and that “lower interest rates only justify higher valuations if the stream of future cash flows is held constant” and that “one of the reasons why reliable valuation measures have retained such a high correlation with subsequent market returns across history, regardless of the level of interest rates, is that the impact of interest rates and growth rates on “terminal” valuations systematically offset each other”.

Hussman also again counters the argument that higher profit margins are the new normal, stating that “it’s important to recognize just how dependent elevated profit margins are on maintaining permanently depressed wages and salaries, as a share of GDP” and that “simply put, elevated corporate profit margins are the precise mirror-image of depressed labour compensation” which he contends is unlikely to last in a low unemployment environment.

Hussman presents a profit margin adjusted CAPE as of the 3rd of November, reproduced below, which he contends shows that “market valuations are now more extreme than at any point in history, including the 1929 and 2000 market highs”.

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However, I think that his profit margin analysis is harsh. If you adjust historical earnings upwards for newer higher margin levels, of course the historical earning multiples will be lower. I got to thinking about what current valuations would look like against the past if higher historical profit margins, and therefore earnings, had resulted in higher multiples. Using data from Shiller’s website, the graph below does present a striking representation of the relationship between corporate profits (accepting the weaknesses in using profits as a percentage of US GDP) and interest rates.

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Purely as a thought experiment, I played with Shiller’s data, updating the reported earnings for estimates through 2018 (with a small discount to reflect over-zealous estimates as per recent trends of earnings revisions), recent consensus end 2018 S&P500 targets, and consensus inflation and the 10-year US interest rates through 2018. Basically, I tried to represent the base case from current commentators of slowly increasing inflation and interest rates over the short term, with 2018 reported EPS growth of 8% and the S&P500 growing to 2,900 by year end 2018. I then calculated the valuation metrics PE10, the regular PE (using trailing twelve month reported earnings called PE ttm), and the future PE (using forward twelve month reported earnings called PE ftm) to the end of 2018. I further adjusted the earnings multiples, for 2007 and prior, by applying an (principally upward) adjustment equal to a ratio of the pre-2007 actual  corporate profits percentage to GDP divided by a newly assumed normalised percentage of 8.5% (lower than the past 10-year average around 9% to factor in some upward wage pressures over the medium term). The resulting historical multiples and averages are shown below.

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Based upon this analysis, whilst accepting its deeply flawed assumptions, if 2018 follows the base case currently expected (i.e. no external shocks, no big inflation or interest rates moves, steady if not spectacular earnings growth), the S&P500 currently looks over-valued by 50% to 20% using historical norms. If this time it is different and higher profit margins and lower interest rates are the new normal, then the S&P500 looks roughly fairly-valued and current targets for 2018 around 2,900 look achievable. Mind you, it’s a huge leap in mind-set to assume that the long-term average PE is justifiably in the mid-20s.

I continue to be concerned about increasing corporate leverage levels, as highlighted in my May post from the IMF Global Financial Stability report in April, and the unforeseen consequences of rising interest rate after such a long period of abnormally low rates.

In the interim, to paraphrase an ex-President, it’s all about the earnings stupid!