The REAL Cult Of Equity
There has been a resurgence in recession calls after the past few months' soft data. This is likely wrong. None of the key recession-casting inputs (ISM: PMI 53.5, Real Retail Sales +3.5% y/y, Fixed Private Investment +10% y/y, Auto Sales +17.4%) signal US recession.
No great private imbalances exist. There is no over-investment. No great over-confidence in sentiment exists. Marginal investment opportunities are fatter & juicier than at any other time in modern history. With this back-drop, from where does a recession emerge?
Drawdown of PCE as a % of wages:
A nation does not spontaneously withdraw from working hard to pursue a better life for today (by consuming) and tomorrow (by investing). The American dream is not dead: 82% of renters aged 25-34 want to own a house in the next 5 years, and that number represents a majority for every renting age group through 65.
As Conor Sen concluded in his June 25th piece, the capital structure impediments are receding into the a temporary demographic lull in housing bids. The smaller Generation X has not been capable of picking up the slack left by the drying Boomer demand. An under-appreciated fact is that the Millennial Generation is larger than the Boomers, and will likely be the largest and richest generation to walk the earth.
But even whilst we wait for the Millennial Generation to grow up and buy some houses, we are already seeing an emerging indication that the liquidation of housing inventory points to an end to the residential drag on GDP. Since October of 2010, the pace of New One-Family Houses Sold has increased by 26.8%, and the Median Sale Price of New Homes Sold is up 14.8%.
This is not the sign of an economy that is teetering on recession.
Rather, the things that matter to the core economic engine of this country are on the up-swing. Consider the Temporary Business & Professional payrolls, which substantially lead payrolls (and the economy) in aggregate:
It is much more difficult to forecast the marginal flows of economic activity (analog) than recession-casting (binary). It seems unlikely that any one or institution has the ability to forecast whether we get 2% or 3% GDP to any degree of reliability. Fortunately, for the moment, for the purposes of asset allocation, the extremes in valuation point to a very binary payoff.
We measure valuation here chiefly with two measurements of the Equity Risk Premium. There are many different ways to measure it, but the most typical definition of the Equity Risk Premium is to subtract the 10-year US Treasury yield from the S&P 500 Earnings Yield (EY – 10y). Whilst imperfect, previous plateaus and troughs in valuation have very neatly coincided with major turning-points in the US stock market.
The argument made against the Equity Risk Premium as calculated this way is that the Federal Reserve has artificially depressed the yields of risk-free instruments. In order to present a view of the distorted premium on fixed cash-flows that the market has in an act of risk-aversion, rather than Fed intervention, we show a lesser-known measurement of the equity risk premium — the Levered Equity Risk Premium. We calculate this by subtracting the Baa yield from the S&P 500 Earnings Yield (EY – Baa). This premium on fixed cash-flows represents two markets the Federal Reserve does not participate in to form a more pure view.
If anything, it paints an even more convincing picture. When LERP is at least 1.5%, the mean quarterly performance jumps from 1.6% to 2.76%. Similarly, the mean 52-week return jumps from 8% to 15%.
|Full sample||When LERP >= 1.5%|
|6 month mean return||3.89%||8.23%|
|12 month mean return||7.9%||15.2%|
|24 month mean return||16.21%||28.85%|
|24 month minimum return||-47.48%||6.28%|
Perhaps what is most interesting – even more so than the roughly double average return expectancy – is the risk minimising effect buying at this extreme relative valuation threshold.
A combination of factors explain this out-performance. The first, and most obvious, is the temporary and mean-reverting nature of risk-averse behaviour. See the long-term chart of the bond:stock ratio with the S&P 500:
To solidify the view as to how mean-reverting this series really is, take this scatter-plot of the bond-stock ratio against forward 2-year returns:
Whilst imperfect, there is not much room for interpretation: strong bids for bonds result in future equity gains.
The second supporting argument may be even more compelling: whilst households tend to not correctly respond to economic incentives (evidenced by their herd-like behaviour in and out of asset classes), corporations rarely fail to take advantage of them.
The major driver is the cultural reverence for shareholders. James Surowiecki wrote a piece in 2008 which contrasted Japanese with American business outcome optimisation. He wrote:
In the 1990s, the average return on equity for the Nikkei was around four per cent, and in the second half of that decade and into the early years of this one it fell below two per cent. (In the U.S., the average R.O.E. is closer to eleven to twelve per cent.) According to this report, between 1998 and 2003, of all large-cap Japanese companies, only eight had an R.O.E. above ten per cent, which is a completely ordinary performance by U.S. standards. And even now, Japan's average R.O.E. is by far the lowest of any major economy. What this means is that for much of the past two decades, Japanese companies have been destroying economic value for shareholders, using far more capital than they're generating.
And further on:
None of this is too surprising—historically, Japanese companies have been disdainful of the idea of shareholder value and of traditional profit metrics. In 1998, the chairman of Mitsubishi Heavy Industries famously said, "I openly brag that I don't cater to shareholders," and, even more amazingly, "We don't give a hoot about things like return on equity." In part, this is because companies' heavy reliance on debt financing and interlocking relationships meant that they felt they didn't need shareholders. It's also because many companies saw themselves as fulfilling a social role.
To accurately forecast the direction of security prices, we have to understand the motivations of the marginal players. The purpose of capital, whether it's raised by debt or equity, is to seek a return. Businesses have used external sources of capital for funding, which has provided them opportunity to spread the risk, and investors to achieve returns on their capital.
Something curious has happened in the past decade, however: the business sector has become nearly self-funded. They have been so saturated with the capital from retained earnings that external capital is converging on non-essential for running operations.
Instead, the corporate sector has increasingly been using it to conduct capital structure arbitrage — taking advantage of the extremely cheap debt capital to reward the more expensive equity capital holders. This is the true cult of equity.
Households will probably continue to shed their equities for fixed income instruments. Hedge funds will probably continue to be both the tail and the dog (and probably make no money in aggregate: it's tough being the marginal player!). But it's the shareholders, ultimately, that constitute the boards. Unlike Japan, even without the need for outside capital, the deified shareholder class is still the ultimate stakeholder to satisfy, and CFOs will respond to the most obvious and strong incentives.
Companies have been buying back stock for decades without any immediate economic incentive. When the Levered Equity Risk Premium is positive, that means that corporations can borrow at a lower rate than their own shares are yielding. While borrowing to fund buy-backs actually increases returns on equity, we can expect CFOs to do it.
The lull between the Baby Boomer & Millennial generations has provided a volatile environment to own equities, and has driven an extreme concentration in equity ownership. While the volatility may not be over, this unique capital structure arbitrage opportunity has provided a cushion for those who are amassing assets to ultimately sell to Millennials as they grow up, get high paying jobs, and start investing for their future.
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