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Dear Mr. Market, "It's Not Different This Time"

Via Gerard Minack's Downunder Daily,

Dear Mr. Market,

I’m writing to you about the sharp lift in equity valuations over the past month (Exhibit 1).

 

I know you sometimes move in ways to cause maximum pain to investors, but I’m not sure that’s the case now.  Investors may not have expected the sharp rally, but sentiment surveys suggest that most investors are long stocks.  Most, in fact, dislike bonds a lot even if they don’t love equities.

I know you are forward-looking, so perhaps the PE expansion is anticipating a sharp lift in earnings.  That would be brave.  In any case, it’s unusual for equity markets to rally when earnings are being downgraded as sharply as they are now (Exhibit 2).

 

Trying to forecast valuation changes is always difficult.  I remember my old colleague, Adam Parker, Morgan Stanley’s US equity strategist, did a lot of work on how to forecast PE changes and concluded there was no reliable model.   (Your MS contact can forward Forecasting the Forward Multiple: A Hubristic Statistic? 29 October 2012.)

Despite Adam’s warning, I had expected that valuations would stop rising this year, so equity gains would depend on earnings growth.  I was relying on correlations that had, in the recent past, given some guidance on PE changes.  But those correlations seem to be breaking down.   First, equity valuations have risen even as credit spreads have widened (Exhibit 3).

 

Second, equity valuations have risen even as implied volatility has modestly risen (Exhibit 4).

 

Third, equity valuations have risen even though macro data are not surprising on the upside (Exhibit 5).  To be fair, the correlation between macro data and valuations broke down after Mr. Draghi promised ‘whatever it takes’.  But the valuation rise seemed to peter out last year.

 

So what’s up, Mr. Market?  Many investors think you aren’t your usual self because you’ve imbibed too much central bank hooch.   My own view is that interest rates matter – they always do – but that the central bankers’ new brew, QE, hasn’t had a huge effect on equities.  There’s been no sustained link between QE and equity valuations (Exhibit 6).

 

But that still suggests that exceptionally low interest rates may be pushing equity valuations higher.  However, while equity valuations usually rise as rates fall, history suggests that when rates fall to low levels investors demand a higher equity risk premium (ERP – the extra reward expected for holding equities versus a safe asset).

 

Exhibit 7 shows an estimate of the ERP for MSCI developed market equities, versus the real G7 10 year bond yield.   The risk premium is above its long-run average.  But that is to be expected with bond yields low.  In fact, the ERP is around 2% lower than the best fit line suggests it should be with real yield as low as they are now.   That’s a big deal: a ‘normal’ low yield ERP implies a prospective PE now of around 12½, rather than the current PE of 16½.  Put another way, equity prices should be 25% lower than they are now.

It’s the same story for the US (Exhibit 8, where the ERP is based on a cycle-adjusted trailing earnings yield).  The US equity risk premium is now very low, given the low real bond yield.

 

So here’s why I’m writing, Mr Market, I want to know if this time is different.   If, unlike in the past, equity investors now no longer worry about the message that exceptionally low bond yields are sending, then we could see further equity valuation gains.  On the other hand, Mr. Market, you have got form whenever people think this time is different.  You then show them that it’s not.

Yours,
Mr. Perplexed.