“To me it appears that the market is too volatile, it’s just noisy because people are a little crazy”.
Robert Shiller, 8th December 2013 during his prize Lecture for The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013
Last year the S&P 500 delivered a total return of just over 32%, while underlying profits are expected to have risen by around 11% (see figure 1 – we won’t know a definite number until all companies in the S&P have reported). How should investors think about this return? Has the market gone up too much? Those who know a little about stockmarkets might be tempted to say “yes” – since over the medium term prices go up in line with profits growth. But taking a closer look, it is possible to say “no, that’s not too much” and the reasoning would be that a re-rating of the market was justified. The starting point of valuation a year ago was attractive, which combined with a favourable economic environment has enabled the market to rise significantly more than profits – and in doing so has brought down the risk premium embedded in market pricing. This implies that (other things being equal) investors ought to expect lower market returns from US equities in the period ahead.
The change in rating of the stockmarket (which can be measured by price to earnings ratios, price to book value ratios etc) explains the difference in return between the underlying profits and the price return of the stockmarket. These changes are mostly driven by changes in investor sentiment, accounting for the “excess volatility” of the market – a phenomenon that is widely acknowledged today as we observe the bubbles and crashes that have characterised equity markets in recent years.
Robert Shiller, who was (jointly) awarded the Nobel Prize in Economic Science in 2013 for his empirical work on asset prices, did much of his early academic work on excess volatility. His 1981 Paper was particularly influential, although arguably he was not pointing out anything new, as any student of economic history will have looked at the events of 1929 and noted that markets can be more volatile than fundamentals.
But things have not always gone smoothly for Shiller. Despite being credited for pointing out the stock market bubble in the late 90s and then the US property bubble in the mid 2000s, he has his critics. His book “ Irrational Exuberance” was first published in 1996, a full 3 years before the market peaked. And more recently there are some commentators, (including Professor Jeremy Siegel) who think his valuation measure for the US is now distorted by a change in accounting rules. It does seem odd that Shiller’s CAPE is 25, while measures based on 12 month forward earnings expectations are closer to 16 times.
Ultimately when very smart people have to argue about the accounting treatment of write-offs to sort out whether a market is cheap or not, it’s probably not! Today, after the re-rating of US equities in 2013, it would probably be most appropriate to describe market valuation as neutral. Such an observation does not prevent a further change in rating, as the market is likely to continue to experience excess volatility in an unforecastable way.
The consensus currently expects profits growth of 10% from the companies in the S&P500, based on 4% sales growth. These numbers are close to what analysts normally expect. They are likely to be wrong and tell investors nothing about the future return of the equity market. All that can be said for certain is that the sustainable return from US equities is lower than it was a year ago and that there will probably be some surprises throughout the year!