Monday, March 23, 2015

New-and-Improved Shiller CAPE: Solving the Dividend Payout Ratio Problem

A common criticism of Professor Robert Shiller’s famous CAPE measure of stock market valuation is that it fails to correct for the effects of secular changes in the dividend payout ratio.  Dividend payout ratios for U.S. companies are lower now than they used to be, with a greater share of U.S. corporate profit going to reinvestment.  For this reason, earnings per share (EPS) tends to grow faster than it did in prior eras.  But faster EPS growth pushes up the value of the Shiller CAPE, all else equal.  Distortions therefore emerge in the comparison between present values of the measure and past values.
To give credit where it’s due, the first people to point out this effect–at least as far as I know–were Professor Jeremy Siegel of Wharton Business School and his former student, David Bianco of Deutsche Bank.  Siegel, in specific, wrote about the problem as far back as late 2008, during the depths of the financial crisis, when the Shiller CAPE was steering investors away from a market that he considered to be extremely cheap (see “Jeremy Siegel on Why Equities are Dirt Cheap”, November 18, 2008, link here).
In a piece from 2013, I attempted to demonstrate the effect with two tables, shown below:
The tables portray the 10 year earnings trajectories and Shiller CAPE ratios of two identical companies that generate identical profits and that sell at identical trailing-twelve-month (ttm) P/E valuations. The first company, shown in the first table, pays out 75% of its profit in dividends and reinvests the other 25% into growth (in this case, share buybacks that grow the EPS by shrinking the S). The second company, shown in the second table, pays out 25% of its profit in dividends, and reinvests the other 75% into growth.
As you can see, even though these companies are identically valued in all relevant respects, they end up with significantly different Shiller CAPEs.  The reason for the difference is that the second company reinvests a greater share of its earnings into growth than the first company.  Its earnings therefore grow faster.  Because its earnings grow faster, the act of “averaging” them over a trailing 10 year period reduces them by a greater relative amount.  Measured against that trailing 10 year average, the company’s price, appropriately set in reference to its ttm earnings, therefore ends up looking more expensive.  But, in truth, it’s not more expensive–its valuation is exactly the same as that of the first company.
The following chart illustrates the effect:
To summarize the relationship:
  • Lower Payout Ratio –> Higher Earnings Growth –> Higher CAPE, all else equal
  • Higher Payout Ratio –> Lower Earnings Growth –> Lower CAPE, all else equal
Now, how can we fix this problem?  A natural solution would be to reconstruct the CAPE on the basis of total return (which factors in dividends) rather than price (which does not). But that’s easier said than done.  How exactly does one build a CAPE ratio–or any P/E ratio–on the basis of total return?
Enter the Total Return EPS Index, explained here and here.  The Total Return EPS Index is a modified version of a normal EPS index that tells us, hypothetically, what EPS would have been, now and at all times in history, if the dividends that were paid out to shareholders had not been paid out, and had instead been diverted into share buybacks. Put differently, Total Return EPS tells us what earnings would have been if the dividend payout ratio had been 0% at all times.  In this way, it reduces all earnings data across all periods of history to the same common basis, allowing for accurate comparisons between any two points in time.
Crucially, in constructing the Total Return EPS, we assume that the buybacks are conducted at fair value prices, prices that correspond to the same valuation in all periods (equal to the historical average), rather than at market prices, which are erratic and often groundless.  To those readers who continue to e-mail in, expressing frustration with this assumption–don’t worry, you’re about see why it’s important.
The following chart shows the Total Return EPS alongside the Regular EPS from 1871 to 2015.  In this chart and in all charts presented hereafter, the index is the S&P 500 (and its pre-1957 ancestry), the values are appropriately inflation-adjusted to February 2015 dollars, and no corrections are made for the effects of questionable accounting writedowns associated with the last two economic downturns:
Now, if all S&P 500 dividends had been diverted into share buybacks, then the price of the index would have increased accordingly. We therefore need a Total Return Price index–an index that shows what prices would have been on the “dividends become buybacks” assumption.
Calculating a Total Return Price index is straightforward.  We simply assume that the market would have applied the same P/E ratio to the Total Return EPS that it applied to the Regular EPS (and why would it have applied a different P/E ratio?). Multiplying each monthly Total Return EPS number by the market’s ttm P/E multiple in that month, we get the Total Return Price index.
In the chart below, we show the Total Return Price index for the S&P 500 alongside the Regular Price, from 1871 to 2015:
Generating a CAPE from these measures is similarly straightforward.  We divide the Total Return Price by the trailing 10 year average of the Total Return EPS.  The result: The Total Return EPS CAPE.
Shiller himself proposed a different method for calculating a CAPE based on total return in a June 2014 paper entitled “Changing Times, Changing Valuations: A Historical Analysis of Sectors within the U.S. Stock Market: 1872 to 2013″ (h/t James Montier). The instructions for the method are as follows: Use price and dividend information to build a Total Return Index. Then, scale up the earnings by a factor equal to the ratio between the Total Return Index and the Price Index.  Then, divide the Total Return Index by the trailing ten year average of the scaled-up earnings.  In a piece from August of last year, I tried to build a CAPE based on Total Return using yet another method (one that involves growing share counts), and arrived at a result identical to Shiller.  The technique and charts associated with that method are presented here.
It turns out that both of these methods produce results identical to the Total Return EPS CAPE method, with one small adjustment: that we conduct the buybacks that form the Total Return EPS at market prices, rather than at fair value prices as initially stipulated. The following chart shows the three types of Total Return CAPEs together.  As you can see, the lines overlap perfectly.
The three different versions of the CAPE overlap because they are ultimately doing the same thing mathematically, though in different ways.  Given that they are identical to each other, I’m going to focus only on the Total Return EPS version from here forward.  I’m going to refer to the version that conducts buybacks at fair value prices as “Total Return EPS (Fair Value) CAPE”, and the version that conducts buybacks at market prices as “Total Return EPS (Market) CAPE.”  I’m going to refer to Shiller’s original CAPE simply as “Shiller CAPE.”
The following chart shows the Total Return EPS (Market) CAPE alongside the Shiller CAPE, with the values of the former normalized so that the two CAPEs have the same historical average (allowing for a direct comparison between the numbers).
(Note: in prior pieces, I had been comparing P/E ratios to their geometric means. This is suboptimal. The optimal mean for a P/E ratio time series is the harmonic mean, which is essentially what you get when you take an average of the earnings yields–the P/E ratios inverted–and then invert that average.  So, from here forward, in the context of P/E ratios, I will be using harmonic means only.) (h/t and #FF to @econompic, @naufalsanaullah, @GestaltU_BPG)
The current value of the Shiller CAPE is 27.5, which is 93% above its historical average (harmonic) of 14.2.  The current value of the Total Return EPS (Market) CAPE is 30.3, which is 71% above its historical average (harmonic) of 17.8.  Normalized to matching historical averages, the current value of the Total Return EPS (Market) CAPE comes out to 24.2.
At current S&P 500 levels, then, we end up with 27.5 for the Shiller CAPE, and 24.2 for the Total Return EPS (Market) CAPE, each relative to a historical average of 14.19. Evidently, the difference between the two types of CAPEs is significant, worth 12%, or 250 current S&P points.
But there’s a mistake in this construction.  To find it, let’s take a closer look at the chart:
From the early 1990s onward, the Total Return EPS (Market) CAPE (the red line) is significantly below the Shiller CAPE (the blue line), suggesting that the Shiller CAPE is overstating the market’s expensiveness, and that the Total Return EPS (Market) CAPE is correcting the overstatement by pulling the metric back down.
What is driving the Shiller CAPE’s apparent overstatement of the market’s expensiveness? The obvious answer would seem to be the historically low dividend payout ratio in place from the early 1990s onward.  All else equal, low dividend payout ratios push the Shiller CAPE up, via the increased growth effect described earlier.
But look closely.  Whenever the market is expensive for an extended period of time, the subsequent Total Return EPS (Market) CAPE (the red line) ends up lower than the Shiller CAPE (the blue line), by an amount seemingly proportionate to the degree and duration of the expensiveness.  Note that this is true even in periods when the dividend payout ratio was high, e.g, the periods circled in black: the early 1900s, the late 1920s, and the late 1960s.  If the dividend payout ratio were the true explanation for the deviations between the Shiller CAPE and the Total Return EPS (Market) CAPE, then we would not get that result.  We would get the opposite result: the high dividend payout ratio seen during the periods would depress the the Shiller CAPE relative to the more accurate total measures; it would not push the Shiller CAPE up, as seems to be happening.
The converse is also true.  Whenever the market is cheap for an extended period of time, the subsequent Total Return EPS (Market) CAPE (the red line) ends up higher than the subsequent Shiller CAPE (the blue line), by an amount seemingly proportionate to the degree and duration of the cheapness.  We see this, for example, in the periods circled in green: the early 1920s and the early 1930s through the end of the 1940s.  The deviation between the two measures is spatially small in those periods, but that’s only because the numbers themselves are small–single digits.  On a percentage basis, the deviation is sizeable.
The following chart clarifies:
So what’s actually happening here?  Answer: valuationnot the dividend payout ratio–is driving the deviation.  In periods where the market was cheap in the 10 years preceding the calculation, the Total Return EPS (Market) CAPE comes out above the Shiller CAPE. In periods where the market was expensive in the 10 years preceding the calculation, the the Total Return EPS (Market) CAPE comes out below the Shiller CAPE.  The degree above or below ends up being a function of how cheap or expensive the market was, on average.
The following chart conclusively demonstrates this relationship:
The bright green line is the difference between the Total Return EPS (Market) CAPE and the Shiller CAPE as a percentage of the Shiller CAPE.  When the bright green line is positive, it means that the red line in the previous chart was higher than the blue line; when negative, vice-versa.  The pink line is a measure of how cheap or expensive the market was over the preceding 10 years, on average and relative to the historical average. When the pink line is positive, it means that the market was cheap; when negative, expensive.  The two lines track each other almost perfectly, indicating that the valuation in the preceding years–and not the payout ratio–is driving the deviation between the two measures.
What is causing this weird effect?  You already know.  The share buybacks associated with the Total Return EPS (Market) CAPE are being conducted at market prices, rather than at fair value prices.  The same is true for the dividend reinvestments associated with Shiller’s proposed Total Return CAPE and with the version I presented in August of last year; those reinvestments are being conducted at market prices.  That’s wrong.
When share buybacks (or dividend reinvestments) are conducted at market prices, then periods of prior expensiveness produce lower Total Return EPS growth (because the dividend money is invested at unattractive valuations that offer low implied returns).  And, mathematically, what does low growth do to a CAPE, all else equal?  Pull it down.  Past periods of market expensiveness therefore pull the Total Return EPS (Market) CAPE down below the Shiller CAPE, as observed.
Conversely, periods of prior cheapness produce higher Total Return EPS growth (because the dividend money is reinvested at attractive valuations that offer high implied returns).  And what does high growth do to a CAPE, all else equal?  Push it up.  Past periods of market cheapness therefore push the Total Return EPS (Market) CAPE up above the Shiller CAPE, as observed.
Looking at the period from the early 1990s onward, we assumed that the problem was with the Shiller CAPE (the blue line), that the low dividend payout ratio during the period was pushing it up, causing it to overstate the market’s expensiveness.  But, in fact, the problem was with ourTotal Return EPS (Market) CAPE (the red line).  The very high valuation in the post-1990s period is depressing Total Return EPS (Market) growth (the expensiveness of the share buybacks and dividend reinvestments shrinks their contribution), pulling down on the Total Return EPS (Market) CAPE, and causing it to understate the market’s  expensiveness.
The elimination of this distortion is yet another reason why the buybacks and dividend reinvestments that form the Total Return EPS (or any Total Return Index used in valuation measurements) have to be conducted at fair value prices, rather than at market prices.  Conducting the buybacks and dividend reinvestments at fair value prices ensures that they provide the same accretion to the index across all periods of history, rather than highly variable accretion that inconsistently pushes up or down on the measure.
Now, a number of readers have written in expressing disagreement with this point.  To them, I would ask a simple question: does it matter to the current market’s valuation what the market’s valuation happened to be in the distant past?
Suppose, for example, that in 2009, investors had become absolutely paralyzed with fear, and had sold the market’s valuation down to a CAPE of 1–an S&P level of, say, 50. Suppose further that the earnings and the underlying fundamentals had remained unchanged, and that investors had exacted the pummeling for reasons that were entirely irrational. Suppose finally that investors kept the market at the depressed 1 CAPE for two years, and that they then regained their senses, pushing the market back up to where it is today, in a glorious rally.  In the presence of these hypothetical changes to the past, what would happen to the current value of a Total Return EPS CAPE that reinvests at market prices?  Answer: it would go up wildly, dramatically, enormously, because the intervening dividends that form the Total Return index would have been invested at obscenely low valuations during the period, producing radically outsized total return growth.  What does high growth due to a CAPE? Push it up, so the CAPE would rise–by a large amount.
Is that a desirable result?  Do we want a measure whose current assessment of valuation is inextricably entangled in the market’s prior historical valuations, such that the measure would judge the valuations of two markets with identical fundamentals and identical prices to be significantly different, simply because one of them happened to have traded more cheaply or expensively in the past?  Obviously not.  That’s why we have to conduct the buybacks and reinvestments that make up the Total Return EPS at fair value.
The general rule is as follows.  When we’re using a Total Return index to model actual investor performance–what an individual who invested in the market would have earned, in reality, with the dividend reinvestment option checked off–we need to conduct the hypothetical reinvestments that make up the Total Return index at market prices.  But when we’re using a Total Return index to measure valuation–how a market’s price compares with its fundamentals–then we need to conduct the hypothetical reinvestments at fair value prices.
The following chart shows the Total Return EPS CAPE properly constructed on the assumption that the buybacks and reinvestments occur at fair value prices:
As you can see, the deviation between the two measures comes out to be much smaller. Normalized to the same historical average, the current value of the Total Return EPS (Fair Value) CAPE ends up being 25.9, versus 27.5 for the original Shiller CAPE.  The difference between the total return and the original measures comes out at 5.7%, a little over 100 current S&P points (versus 12% and 250 points earlier).
Surprisingly, then, properly reinvesting the dividends at the same valuation across history more than cuts the deviation in half, to the point where it can almost be ignored.  As far as the CAPE is concerned, when it comes to the kinds of changes that have occurred in the dividend payout ratio over the last 144 years, there appears to be little effect on the accuracy of Shiller’s original version.  The entire exercise was therefore unnecessary. Admittedly, this was not the result that I was anticipating, and certainly not the result that I was hoping to see.  But it is what it is.
It turns out that Shiller was right to reject the dividend payout ratio argument in his famous 2011 debate with Siegel and Bianco:
“Mr. Shiller did his own calculation about the impact of declining dividends on earnings growth and concluded that it is marginal at best, not meriting any adjustment.” — “Is the Market Overvalued?”, Wall Street Journal, April 9th, 2011.
If the subsequent foray into Total Return space caused him to change that view, then he should change it back.  He was right to begin with.  His critics on that point, myself included, were the ones that were wrong.
Now, this is not to suggest that we shouldn’t prefer to use the Total Return version of the CAPE over Shiller’s original version.  We should always prefer to make our analyses as accurate as possible, and the Total Return version of the CAPE is unquestionably the more accurate version.  Moreover, even though the changes in the dividend payout ratio seen in the U.S. equity space over the last 144 years have not been large enough to significantly impact the accuracy of the original version of the CAPE, the differences between the payout ratios of different countries–India and Austria, to use an extreme example–might still be large enough to make a meaningful difference.  Since the Shiller CAPE is the preferred method for accurately comparing different countries on a valuation basis, it only makes sense to shift to the more accurate Total Return version.  Fortunately, that version is simple and intuitive to build using Total Return EPS.
Admittedly, there is some circularity here.  In building the Total Return EPS Index on the assumption of fair value buybacks, we used the Shiller CAPE as the basis for estimating fair value.  If the Shiller CAPE is inaccurate as a measure of fair value, then our Total Return EPS index will be inaccurate, and therefore our Total Return CAPE, which is built on that index, will be inaccurate.  Fortunately, in this case, there’s no problem (otherwise I wouldn’t have done it this way). When you run the numbers, you find that the choice of valuation measure makes little difference to the final product, as long as a roughly consistent measure is used.  You can build the Total Return EPS Index using whatever roughly consistent measure you want–the Total Return CAPE will not come back appreciably different from Shiller’s original. What drove the deviations in the earlier charts were not small differences in the valuations at which dividends were reinvested, but large differences–for example, the difference associated with reinvesting dividends at market prices from 1942 to 1952, and then from 1997 to 2007, at prices corresponding to three times the valuation.
Now, there are other ways of adjusting for the impact of changing dividend payout ratios. Bianco, for example, has a specific technique for modifying past EPS values. As he explains:
“The Bianco PE is based on equity time value adjusted (ETVA) EPS.  We raise past period EPS by a nominal cost of equity estimate less the dividend yield for that period.”
I cannot speak confidently to the accuracy of Bianco’s technique because I do not have access to its details.  But if the method produces a result substantially different from the Total Return EPS CAPE (which it appears to do), then I would think that it would have to be wrong.  When it comes to changing dividend payout ratios, the Total Return EPS CAPE is airtight.  It treats all periods of history absolutely equally in all conceivable respects, perfectly reducing them to a common basis of 0% (payout).  Because it reinvests the dividends at fair value (the historical average valuation), every reinvested dividend in every period accretes at roughly the same rate, which corresponds to the actual average rate at which the market has historically accreted gross of dividends (approximately 6% real).
If our new-and-improved version of the CAPE is appropriately correcting the dividend payout ratio distortions contained in the original version, then the deviation between our new-and-improved version and the original version should be a clean function of that ratio (rather than a function of other irrelevant factors, such as past valuation).  When the dividend payout ratio is low, our new-and-improved version should end up below the original version, given that the original version will have overstated the valuation.  When the dividend payout ratio is high, our new-and-improved version should end up above the original version, given that the original version will have understated the valuation.
Lo and behold, when we chart the deviation between the two versions of the CAPE alongside the dividend payout ratio, that is exactly what we see: a near-perfect correlation (91%), across the full 134 year historical period.
The blue line shows the difference between our new-and-improved version of the CAPE and the original version.  The red line shows the trailing Shiller dividend payout ratio, which is the 10 year average of real dividends per share (DPS) divided by the 10 year average of real EPS.  We use a Shillerized version of the dividend payout ratio to remove noise associated with recessions–especially the most recent one, where earnings temporarily plunged almost to zero, causing the payout ratio to temporarily spike to a value north of 300%.
The fact that the two lines overlap almost perfectly indicates that the deviation between our new-and-improved version and the original version is a function of the factor–the dividend payout ratio–that is causing the inaccuracy in the original version, rather than some other questionable factor.  That is exactly what we want to see.  It is proof positive that our new-and-improved version is correcting the distortion in question, and not introducing or exploiting other distortions (that, conveniently, would make the current market look cheaper).
Now, to be clear, the secular decline in the dividend payout ratio seen across the span of U.S. market history has not substantially affected the accuracy of the original Shiller CAPE.  However, it has substantially affected the trend growth rate of EPS.  So, though it may not be imperative that we use the Total Return version of the CAPE when measuring valuation, it is absolutely imperative that we use the Total Return version of EPS when analyzing earnings trends and projecting out future earnings growth.
We are left with the question: if the distortions associated with the dividend payout ratio are not significant, then why does the Shiller CAPE show the U.S. equity market to be so expensive relative to history?  We can point to three explanations.
  • First, on its face, the market just is historically expensive–even on a non-Shiller P/E measurement.  Using reported EPS, the simple trailing twelve month P/E ratio is roughly 20.5, which is 53% above its historical average (harmonic) of 13.4.  Using S&P corporation’s publication of operating EPS, the simple trailing twelve month P/E ratio is 18.8, which is 40% above that average.
  • Second, the accounting writedowns associated with the 2008-2009 recession are artificially weighing down the trailing average 10 year EPS number off of which the Shiller CAPE is calculated.  Prior to 2014, this effect was more significant than it is at present, given that the 2001-2003 recession also saw significant accounting writedowns.  The trailing 10 year average for the years up to 2014 therefore got hit with a double-whammy.  That’s why the the increase in the Shiller CAPE in recent years has not been as significant as the increase in market prices (since December 2012, the CAPE is up roughly 30%, but prices are up roughly 50%).  2014 saw the 2001-2003 recession fully drop out of the average, reducing the CAPE’s prior overstatement.
  • Third, as the chart below shows, real EPS growth over the last two decades–on both a regular and a Total Return basis–has been meaningfully above the respective historical averages, driven by substantial expansion in profit margins.  Recall that high growth produces a high CAPE, all else equal.
These last two factors–the effects of accounting writedowns and the effects of profit margin expansion–will gradually drop out of the Shiller CAPE (unless you expect another 2008-type recession with commensurate writedowns, or continued profit margin expansion, from these record levels).  As they drop out, the valuation signal coming from the Shiller CAPE will converge with the signal given by the simple ttm P/E ratio–a convergence that is already happening.
We conclude with the question that all of this exists to answer: Is the market expensive? Yes, and returns are likely to be below the historical average, pulled down by a number of different mechanisms.  Should the market be expensive?  “Should” is not an appropriate word to use in markets.  What matters is that there are secularsustainable forces behind the market’s expensiveness–to name a few: low real interest rates, a lack of alternative investment opportunities (TINA), aggressive policymaker support, and improved market efficiency yielding a reduced equity risk premium (difference between equity returns and fixed income returns).  Unlike in prior eras of history, the secret of “stocks for the long run” is now well known–thoroughly studied by academics all over the world, and seared into the brain of every investor that sets foot on Wall Street.  For this reason, absent extreme levels of cyclically-induced fear, investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go–as they did, for example, in the 1940s and 1950s, when they had limited history and limited studied knowledge on which to rely.
As for the future, the interest-rate-related forces that are pushing up on valuations will get pulled out from under the market if and when inflationary pressures tie the Fed’s hands–i.e., force the Fed to impose a higher real interest rate on the economy.  For all we know, that may never happen.  Similarly, on a cyclically-adjusted basis, the equity risk premium may never again return to what it was in prior periods, as secrets cannot be taken back.

Wednesday, March 11, 2015

Markets More: Chart Of The Day Bull Market The stock market has gone up this far, this fast only twice since 1900

Read more:

Wednesday, February 25, 2015

Howard Marks Video : Stick to your approach

Monday, February 23, 2015

This Won't End Well

With the S&P 500 now in positive territory for the year and the mainstream media back in normal cheerleading mode, it is worth noting that 1) "Most shorted" stocks have outperformed the broad market this year, 2) the last 3 weeks have seen the biggest short squeeze in almost 4 years, and 3) Hedge funds are now at a record high 57% net long. We suspect, given the looming Humphrey-Hawkins and March FOMC and the short-term 'gap' between the market and fun-durr-mentals, volatility will be on the rise again.

The "Most Shorted" stocks outperformed the broad market in 2015 so far...
Amid the biggest short squeeze since 2011...
Hedge funds have never been more net long the market...
Short positions shed light on the “other side” of fund portfolios
We combined $1.5 trillion of single-stock and ETF long holdings in 13-F filings of 854 hedge funds with our estimate of hedge fund short positions. We estimate hedge funds accounted for 85%, or $627 billion, of the $738 billion in single-stock, ETF and market index short interest positions filed with exchanges as of December 31, 2014.
Our analysis suggests that hedge funds operate 57% net long (net/long), a new record.
And the yawning chasm between markets and macro and micro is daunting to all but the most 'ignorant'...

Wednesday, February 11, 2015

To Hedge or Not to Hedge Currency in International Stock Portfolios: Morningstar

Currency-hedged exchange-traded funds have come into vogue of late in the United States. Investor interest was first piqued by the performance of the oldest and largest of them all:  WisdomTree Japan Hedged Equity  (DXJ). The fund owns a portfolio of dividend-paying Japanese stocks that generate more than 80% of their revenue outside of Japan. It gained nearly 42% in 2013, as a massive dose of monetary stimulus contributed to an 18% decline in the value of the Japanese yen, and steady improvement in the global economy gave Japan's stock market an additional boost. In contrast,  iShares MSCI Japan ETF (EWJ), which tracks a standard market-cap-weighted benchmark and does not hedge its yen exposure, increased by 26% in 2013. Clearly, it paid for U.S. investors in Japanese stocks to have a hedge against a declining yen over this span. But was this a flash in the pan, or do currency hedges have value over longer time frames? With the U.S. dollar marching steadily higher--thanks in part to (relatively) attractive interest rates--and double-digit moves in major currencies making headlines, now is a good time for investors to explore these questions.

Back to Basics: Return, Risk, and the Practicalities of Putting a Currency Hedge in Place
In simple terms, a domestic investor's local-currency-denominated return in a foreign security (or a portfolio of them) is equal to the foreign security's (or portfolio's) return plus the foreign currency return, plus the product of the foreign security return and the foreign currency return. The last part of this equation accounts for the interplay between the two, and as it is the product of these two figures, its contribution to the overall return will grow as either the foreign asset return or the foreign security return grows larger.

Domestic Currency Return = Foreign Security Return + Foreign Currency Return + (Foreign Security Return x Foreign Currency Return)

The effect of fluctuating exchange rates can either help or hurt returns. In the case of U.S. investors holding Japanese stocks, the yen's depreciation hurt the U.S. dollar return for unhedged investors in 2013, as evidenced in part by the iShares fund's relative underperformance versus the WisdomTree offering. In another extreme example, the 34% appreciation of the Brazilian real contributed to the 124% calendar-year return posted by  iShares MSCI Brazil Capped ETF (EWZ) in 2009. These examples highlight that currency effects can be extreme in magnitude.

It's also important to consider currencies' effect on the risk of a portfolio of foreign securities: The expression for the variance (the square root of which is the standard deviation) of a foreign security or portfolio's returns is as follows:

σ2$ = σ2LC + σ2S + 2σLCσSρLC,S,


σ2$ = the variance of the foreign asset returns in U.S. dollar terms;

σ2LC = the variance of the foreign asset in local-currency terms;

σLC = the standard deviation of the foreign asset in local-currency terms;

2S = the variance of the foreign currency;

σs = the standard deviation of the foreign currency;

ρLC,S = the correlation between the returns of the foreign asset in local-currency terms and movements in the foreign currency.

This expression demonstrates that the volatility of a foreign asset in domestic-currency terms is directly related to the volatility of the asset in local-currency terms (the first term in the expression) and the volatility of the foreign currency (the second term). It also shows that the higher the correlation between the foreign asset in local-currency terms and movements in the foreign currency, the greater the variance will be in local currency terms. (Again, take the square root and you'll get the standard deviation.) Hedging away currency exposure will reduce risk, as measured by standard deviation--as can be seen in Exhibit 3 below.

How does currency hedging work in practice? Most currency-hedged ETFs will use currency forward contracts to reduce their foreign-currency exposure. A currency forward contract is an agreement between two parties to buy or sell a prespecified amount of a currency at some point in the future (typically one month out in the case of currency-hedged ETFs) at an exchange rate agreed upon between the two parties. Because the value of the forward contract is fixed ahead of time, and the value of the fund will fluctuate during the course of a month as asset prices and cash flows into and out of the fund fluctuate, the forward may not be a perfect hedge. It's also important to note that these hedges come at a cost, though their price tag typically amounts to just a few basis points in the case of developed-markets currencies in stable interest-rate environments.

FX Effects
It is useful to look at historical data to frame the effects of currency hedging on investment performance (for U.S. investors in this case). There are two key elements to consider when assessing the effects of currencies on equity portfolios: their contribution to return (as covered above) and their contribution to risk.

Exhibit 1 shows "success ratios" for a trio of MSCI benchmarks over the 20-year period ended Jan. 31, 2015. These benchmarks are all tracked by one or more currency-hedged (and unhedged) ETFs. The success ratio represents the portion of the overlapping monthly rolling one-, three-, and five-year periods over these two decades during which the unhedged version of the index outperformed its fully hedged counterpart. For example, the MSCI EAFE Index outperformed its fully hedged counterpart in 59% of these overlapping rolling one-year periods over this 20-year span. In hindsight, in the case of the MSCI EAFE and MSCI Germany benchmarks, the winner could have been predicted by the flip of a (mostly) fair coin. The story is different when it comes to the MSCI Japan Index, where "getting the yen out" has clearly paid off more often than not.

Exhibit 2 contains the annualized average returns for each benchmark across each of the overlapping monthly rolling one-, three-, and five-year periods dating back 20 years from the end of January 2015. The differences in relative performance vary between the hedged and unhedged versions of these indexes depending on the length of the measurement period. The MSCI Japan Index is again a unique case, as evidenced by the yawning performance differential between its hedged and unhedged versions.

What about risk? Currency risk is a significant contributor to overall risk in the context of a foreign-equity portfolio. Exhibit 3 shows the trailing 20-year annualized standard deviations and Sharpe ratios for the same benchmarks featured in the first two exhibits. In the case of all three benchmarks, it is clear--as evidenced by the difference in  Sharpe ratios between the U.S. dollar and hedged versions of the indexes--that currency exposure is a meaningful source of risk, currency hedging can serve to mitigate this risk, and it may ultimately result in superior risk-adjusted performance.

To Hedge or Not to Hedge?
The best answer to the question of whether it makes sense to hedge the currency exposure of an international-stock portfolio is this: It depends. By hedging foreign-currency exposure, investors can mitigate a source of risk--but at the expense of a potential source of return. The trade-off between the two is important, and investors' decisions will depend on a variety of factors, including but not limited to their return requirements, risk tolerance, investment horizon, and the costs associated with hedging currency exposure.

High Market Valuations May Signal Low Future Returns: Morningstar / GMO

In the summer of 2000, I vividly recall accompanying John Rekenthaler to meet GMO co-founder Jeremy Grantham in a café in Chicago. Vanguard had just launched its U.S. Value Fund (VUVLX), for which GMO was the subadvisor, and I was the (somewhat) young analyst assigned to cover it. Grantham had agreed to meet to discuss GMO's approach and investment outlook.

I do not remember much about what Grantham said about GMO's approach to selecting individual stocks, but I know that he had a lot to say about market valuations. In particular, he had a firm belief--citing GMO's long-term asset-class forecasts--that U.S. growth stocks were incredibly overvalued. He also said that, as a value-oriented firm, GMO had suffered massive investor redemptions in previous years, thanks to investors' moving assets to more growth-oriented shops.

Of course, subsequent events proved Grantham and GMO correct. For three calendar years in a row, between 2000 and 2002, the Morningstar US Growth Index lost more than 25% of its value. Meanwhile, on a cumulative basis, the Morningstar US Value Index lost just a few percentage points. Fast forward a few years: Grantham and GMO's equity return forecasts proved accurate again in 2007, when they signaled that equity valuations were overheated prior to 2008's market meltdown.

Grantham and GMO are sounding alarms again. In its latest round of seven-year asset-class forecasts (registration required), GMO predicts that U.S. large- and small-cap stocks will deliver negative inflation-adjusted returns, while developed-markets international stocks will produce just slightly positive returns.

In most of the developed world, GMO considers valuations too high to generate solid returns during the next seven years. With respect to valuations, GMO's asset-class forecasts incorporate some amount of mean reversion, so as valuations fall over a market cycle, projected returns will decline as well. Note that GMO is not trying to make a short-term market call; rather, the firm highlights longer-term investment opportunities based, in large part, on valuation measures.

Other fundamentals-based, long-term-oriented valuation measures are flashing warning signs as well. In particular, Nobel Prize-winning Yale Professor Robert Shiller's favored measure, the cyclically adjusted price/earnings ratio (known as CAPE, or the Shiller P/E), also suggests that U.S. equity investors should temper their expectations for future returns. CAPE--which is a measure of equity prices divided by the past 10 years' earnings, adjusted for inflation--currently suggests that valuations are more than 60% above their historical norm.

Like Grantham, Shiller boasts an enviable record of forecasting asset-class returns. In his 2000 book Irrational Exuberance, Shiller--in contrast to many market commentators at the time--said that the equity market was in bubble territory and would therefore subsequently deliver disappointing returns. Like Grantham, he was right, though it is worth noting that both began raising concerns about market valuations several years earlier. Shiller updated the book in 2005 to argue that there was a bubble in the housing market--a view that also was vindicated when house prices subsequently crashed.

Research has shown that CAPE does an impressive job of forecasting future returns across a variety of equity markets. Based on research using more than a century of earnings and equity return data, Shiller and co-author John Y. Campbell found that CAPE was a strong predictor of U.S. stock returns over subsequent 20-year periods. And a study by Norbert Keimling of Germany's StarCapital has found that the relationship between CAPE and subsequent returns exists in 14 other markets as well. In short, when CAPE is very high, in general relatively low long-term equity returns will follow. (Click here to see current CAPE levels for countries around the world.)

Daniel Needham, Morningstar Investment Management's president and chief investment officer, agrees that "the U.S. market is very overpriced and is at a level that is associated with very low prospective returns." Moreover, Needham says that in this high-valuation, low-interest-rate environment, even small changes in earnings forecasts or interest rates can lead to greater volatility. In short, Needham expects "lower prospective returns and higher prospective volatility."

So, what is an investor to do with this information? Interestingly, despite the much higher-than-normal level of CAPE, Shiller recently told CNBC that he has not yet pulled back on his equity exposure. Despite the fact that "my own indicator (CAPE) is looking kind of scary," Shiller said that his expected longer-term returns from real estate or fixed income are even worse. So, in Shiller's view, equities might be the least bad of some weak alternatives.

Shiller has also pointed out that there may be some pockets of value in global markets. In terms of their asset-class forecasts, GMO's strategists agree. For example, at the end of 2014, GMO projected nearly 4.0% annualized real returns on emerging-markets stocks and a nearly 3.0% real return on emerging-markets debt. Both areas compare favorably with the projected annualized returns of negative 1.8% for U.S. large-cap stocks and negative 2.9% for U.S. small caps. Those seeking emerging-markets exposure would do well to look at Morningstar analyst favorites such as  American Funds New World  (NEWFX) or  Vanguard Emerging Markets Stock Index (VEMAX), while those who want bond exposure in developing markets will want to take a look at the likes of  Fidelity New Markets Income  (FNMIX) and  PIMCO Emerging Markets Bond (PAEMX).

Morningstar's equity research can also help investors uncover attractive opportunities. Although, in the aggregate, Morningstar analysts consider the market somewhat overvalued, there are individual stocks that are attractively priced. Morningstar analysts currently assign 5-star ratings to a couple dozen stocks, including  BHP Billiton  (BHP) Priceline  (PCLN) Apache  (APA), and  Cabot Oil & Gas (COG). Premium Members can define their own criteria to focus on stocks with the characteristics that they most desire.

Of course, when it comes to forecasting market returns, there are no guarantees that any methodology--even those that have often worked in the past--will be absolutely spot-on. But extremely high equity valuations and exceptionally low interest rates tilt the odds against investors. In addition to seeking out pockets of value, perhaps the best things investors can do are avoid counting on unrealistically high returns, save enough to compensate for potentially weak returns, and keep costs to a minimum. Those are not very exciting tips, but they may represent the most useful advice in what is likely to be a low-return environment.

GS Explanation on Oil Prices; Good Chart

Oil prices have gotten crushed for the last six months. The extent to which that was caused by an excess of supply or by a slowdown in demand has big implications for where prices will head next. People wishing for a big rebound may not want to read farther.
Goldman Sachs released an intriguing analysis on Wednesday that shows what many already suspected: The big culprit in the oil crash has been an abundance of oil flooding the market. A massive supply shock in the second half of last year accounted for most of the decline. In December and January, slowing demand contributed to the continued sell-off. Goldman was able to quantify these effects. 

The Culprit Is in Blue

Goldman’s model is simple on its face, looking at just two variables over time: the price of oil and the value of U.S. stocks (as measured by the S&P 500). The idea is that the stock market is a pretty good indicator of economic demand. So when stocks move in tandem with oil prices, demand is in the driver’s seat. When the price of oil moves in the opposite direction of stocks, the shock is coming from supply.
It’s a bit more complicated than that—for the statistically inclined, Goldman uses a “vector autoregression with sign restrictions”—but you get the idea. In the following chart, they split apart the effects of demand shocks (left) from supply shocks (right).

Demand & Supply

The chart on the left shows what you might expect: strong demand leading up to a precipitous decline during the recession beginning in late 2008. The supply chart on the right shows a shock of undersupply in late 2007, leading to years of relatively steady supply expectations. Oversupply shocks picked up, beginning in 2012, as U.S. shale-oil production exceeded expectations, culminating in a piercing shock of oversupply last year that sent markets reeling. 

The big take-away: “[T]he decline in oil has been driven by an oversupplied global oil market,” wrote Goldman economist Sven Jari Stehn. As a result, “the new equilibrium price of oil will likely be much lower than over the past decade.” 

Monday, February 09, 2015

Arnott: ‘Peasants With Pitchforks’ Seen If Profits Get Any Fatter

Rob Arnott, chief executive and co-founder of Research Affiliates LLC, recently picked up the phone to share some thoughts on the current state of the stock market. 

Arnott is a pioneer of investing strategies that could be considered “unconventional” if they weren’t slowly but surely becoming more conventional. Among them is the idea of “fundamental indexing,” or weighting stock portfolios by economic metrics like sales, dividends and cash flows rather than the market value of the companies. (The term “smart beta” came later.) 
As such, fundamental indexes tend to lean toward value stocks instead of growth stocks. How are they doing? Well, the FTSE RAFI U.S. 1000 Total Return Index returned 140 percent in the 10 years through 2014 compared with 114 percent for the Russell 1000 Index, even though growth far outperformed value in the same decade. 
Anyway, when talking to a person like this, sometimes it’s best for a reporter to just shut the heck up, save the bad jokes for the next happy hour, and let the smarter person do all the talking. So here goes. 
Q: Does it seem like the market will move back to a value orientation? 

Bubble ‘Echoes’ 

A: “I think the market’s stretched both in terms of valuation levels and the spread between growth and value. It doesn’t feel like the tech bubble to me, it feels a little bit more like ’98 or early ’99 in terms of the magnitude by which things are stretched. But you do have some relatively extreme examples, companies that are trading at large multiples to revenue, let alone multiples of earnings or cash flow. And that hearkens back to the ’98-’99 experience. So I think we’re seeing echoes of the bubble in today’s global market behavior. 
‘‘There is a flight to safety and the snapback from that, when it comes, will reward the value investor handily. You also see a huge spread between the comfort markets, the United States at a Shiller P/E ratio of 27 times earnings, and the fear markets, emerging markets, where a fundamental index in emerging markets is currently at a Shiller P/E ratio of 10 and a half. My goodness, 60 percent discount to the S&P 500. That’s startling. Why would it trade at such a vast discount? Because people are afraid. Fear breeds bargains. You cannot have a bargain in the absence of fear.” 
(Note: Created by economist Robert Shiller, Shiller P/E ratios measure the price of an index divided by average inflation-adjusted earnings from the previous 10 years. Traditionally, P/E ratios measured either just the prior year’s earnings or forecasts for the next year’s profits.) 
Q: What do you think about the Shiller P/E? Do you give it a little less weight considering the really bad earnings years during the recession? Does that skew it, or is that exactly what it’s meant to do? 

Peasants, Pitchforks 

A: “That’s exactly what it’s meant to do. It includes good times and bad times. Back in 2010 it included good years and two recessions, the ’02-’03 recession and the ’08-’09 recession. Now it includes two boom times and one deep recession, so I’m not troubled by including ’08-’09 at all. 
‘‘Right now we have earnings coming off of record highs as a percentage of GDP and yet you have Wall Street saying ‘don’t worry, it’s going to soar to new highs.’ Pardon me, but when did the peasants with the pitchforks come out and start rioting? Society at large has to enjoy some of the largesse, or else the pitchforks come out. So earnings as a share of GDP can’t really advance materially from current levels, or at least it’s not healthy if they do. 
‘‘So we’re looking at a likely mean reversion on earnings. What happens if there is mean reversion? Is the market ready for that? A strong dollar also points to mean reversion, when you get a strong dollar you usually get weak earnings, and the reciprocal for emerging markets and for Europe.”

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.