Thursday, April 6, 2017

Research Affiliates and The Cyclically Adjusted Earnings Yield Ratio (and its relationship to forward real returns in the market)

The last time we mentioned Rob Arnott & Company Cliff Asness was crabby:
"Investing: Cliff Asness Blasts Rob Arnott
This, on the other hand, seems smarter than feuding over return-factors-and-timing (we lean toward Asness) and although we can't vouch for the forecasting skill of inverting Shiller's CAPE it's an interesting idea.

From ZeroHedge:

The CAEY Ratio & Forward Returns
Over the last couple of week’s (see here and here), I have been discussing the value of Shiller’s CAPE ratio. The Cyclically Adjusted P/E ratio, or CAPE, is often maligned by the media as “useless” and “outdated” because despite the fact the ratio is currently registering the second highest level of valuation is history, the markets haven’t crashed yet.  Of course, the key word is…YET.

In the second article, I shortened the length of the CAPE ratio to make it more sensitive to price movements which sparked a good discussion on Twitter about forward return analysis using a shortened smoothing period. Leave it to my friend John Hussman to do the heavy lifting:
Of course, the obvious question is what are his favorite metrics? Here you go.
Within all of this is a simple point. No matter how you cut it, slice it, dice it, twist it, abuse it, or torture it – valuations matter in the long run.

But therein lies the problem, valuations are NOT, and never have been, a market timing tool. It is about the value you pay for something today and the return you will receive in the future, and a point that Research Affiliates recently took a very interesting approach to in a recent report:
“Academics have suggested various reasons for sustained higher equity valuations, from the microstructure benefits of improved participation and lower transaction costs to the macroeconomic benefits of larger profit shares. We examine the explanation put forward by Lettau, Ludvigson, and Wachter (2008) that rising valuations are propelled by the large reduction of macroeconomic risk in the US economy. Their intuition is simple—investors require lower returns from equity markets when the aggregate volatility of the economy is lower. It should come as no surprise that investors are glad to pay a higher price and accept a lower return for investing in a stock market that delivers less uncertainty.

Today’s economy is drastically different from just a few decades ago, and radically different from a century ago. Judging from the volatility of two major macroeconomic variables—real output growth and inflation—it has changed for the better. From the days before the US Federal Reserve Bank until today, the annual volatility of the economy has tumbled about 80%.

When we plot the measure of macro volatility with the inverse of a very popular valuation metric, Robert Shiller’s cyclically adjusted price/earnings ratio (CAPE), we find an intriguing and significant positive correlation between expected real equity returns and the aggregate volatility of the economy. Under the restrictive assumption that prices are fair and an appropriate return on retained profits, we assert that earnings yields are an appropriate proxy for an equity market’s future real return. For clarity, we name the inverse of the CAPE, an earnings yield, the cyclically adjusted earnings yield (CAEY).
Research Affiliates makes some very interesting points and the entire paper is worth reading. However, I was most interested in the concept of the Cyclically Adjusted Earnings Yield (CAEY) ratio and its relationship to forward real returns in the market.

While the statement that lower valuations, inflation, and lower volatility are supportive of higher valuations is true, there have also been other issues as well as I addressed last week:
  • Beginning in 2009, FASB Rule 157 was “temporarily” repealed in order to allow banks to “value” illiquid assets, such as real estate or mortgage-backed securities, at levels they felt were more appropriate rather than on the last actual “sale price” of a similar asset. This was done to keep banks solvent at the time as they were being forced to write down billions of dollars of assets on their books. This boosted banks profitability and made earnings appear higher than they may have been otherwise. The ‘repeal” of Rule 157 is still in effect today, and the subsequent “mark-to-myth” accounting rule is still inflating earnings.
  • The heavy use of off-balance sheet vehicles to suppress corporate debt and leverage levels and boost earnings is also a relatively new distortion.
  • Extensive cost-cutting, productivity enhancements, off-shoring of labor, etc. are all being heavily employed to boost earnings in a relatively weak revenue growth environment. I addressed this issue specifically in this past weekend’s newsletter.
  • And, of course, the massive global Central Bank interventions which have provided the financial “put” for markets over the last eight years. 
Furthermore, the point suggesting investors are willing to accept lower returns in exchange for lower volatility is intriguing. 

While academically speaking I certainly understand the point, I am not so sure the average market participant does who is still being told to bank on 6-8% annualized rates of return for retirement planning purposes. 

However, this brings us to the inverse of the P/E ratio or Earnings Yield. The earnings yield has often been used by Wall Street analysts to justify higher valuations in low interest rate environment since the “yield on stocks” is higher than the “yield on risk free-assets,” namely U.S. Treasury bonds....MORE
Definitely worth the read as is the referenced paper at Research Affiliates: "Quest for the Holy Grail: The Fair Value of the Equity Market".

Regarding the first of the bullet points, when the FASB started talking about repealing rule 157 we had one of those "Saaay, this might be important" realizations. As recounted in October 2009's "Markets-Where Do We Go From Here?: Bank Earnings (BAC; C; GS; JPM)":

....Another wrinkle is the change the Financial Accounting Standards Board made last spring regarding how banks get to write down/write up their junk assets.
The new rules basically allow them to use whatever valuation they need to meet regulatory capital requirement. Cool huh?

Back when the FASB was considering the change we thought it was a big enough deal to put up multiple posts:

March 25
Banks to Write-UP Assets?
Following my mission critical (coffee a.m., lights p.m.) duties in importance is attempting to ascertain (sometimes feebly) regulatory impacts and how to make a buck off them. Here's one worth looking at, from the National Center for Policy Analysis:...
March 30
Mark-to-Market Lobby Buoys Bank Profits 20% as FASB May Say Yes
April 2
FASB Eases Fair-Value Rules Amid Lawmaker Pressure
April 2
Markets: Why the FASB Decision Matters

On Monday March 30 we posted "Getting Ready for the Wednesday/Thursday Market Pop":
As I said in the post immediately below, reality has attempted to intrude on the blogging.
I won't get all Fibonacci or 50-day on you, this decline has an odd feel to it. We might be setting up a nice mid-week run. The DJIA is currently down 307 at 7468 and the S & P is down 53.81 at 1491....
One of our rationales was the FASB move we'd been reporting was coming.
On Wednesday April 1 we posted "U.S. stock futures slip to start second quarter":
Great. Here I am calling for a midweek pop in the market and Dow futures indicate down 52.
Will this thwart my plans for world domination? In the words of Jimmy James (News Radio):
Mr. James:
"The original title of this book was 'Jimmy James, Capitalist Lion Tamer' but I see now that it's... 'Jimmy James, Macho Business Donkey Wrestler'... you know what it is... I had the book translated into Japanese then back in again into English. Macho Business Donkey Wrestler... well there you go... it's got kind of a ring to it don't it?

Anyway, I wanted to read from chapter three... which is the story of my first rise to financial prominence... I had a small house of brokerage on Wall Street... many days no business come to my hut... my hut... but Jimmy has fear? A thousand times no. I never doubted myself for a minute for I knew that my monkey strong bowels were girded with strength like the loins of a dragon ribboned with fat and the opulence of buffalo... dung. ...Glorious sunset of my heart was fading. Soon the super karate monkey death car would park in my space. But Jimmy has fancy plans... and pants to match. The monkey clown horrible karate round and yummy like cute small baby chick would beat the donkey."
-Episode #57 "Super Karate Monkey Death Car"
By way of
Well there you go. Pretty much says it all....
...By the bye, tomorrow the FASB will meet to decide whether to rescind mark-to-market accounting for the banks, see "Mark-to-Market Lobby Buoys Bank Profits 20% as FASB May Say Yes".
We gave you the rest of the story on May 30:
Thoughts on Markets, Investing and Life
The Dow Jones Industrial Average closed up 152.68 that day and a further 216.48. the next.
The run actually started a day earlier than I thought it would, with an 86 point advance on Tuesday.

Mom used to say, "It's great fun to fool around, just get your homework done first."
And there you go. One of the reasons we posted "Do not sell equities, Credit Suisse says" a week ago....

Sometimes half the battle is just paying attention.