It was an eventful week. Investors began to put 2009 behind them and began to reassess risk properly. The process is ongoing. Economic data in many places have taken a turn for the worse. Retail sales slumped in Australia in December and unemployment jumped in New Zealand. German industrial production and factory orders—which led and paced the so-called recovery last year—are “unexpectedly” declining. The number of displaced American workers queuing up to claim unemployment benefits has begun to rise again.
One broker wrote that fears fog fundamentals. Hmmm. When asset prices decline, it is due to fear and when they rise, it is due to fundamentals. No wonder American policymakers have modelled their behaviour on this framework—at least until now.
On Friday’s CNBC Worldwide Exchange, one of the anchors asked me why markets should now fret over Greece when their problems have been known for a long time. I responded that the right question to ask was different: Why did the markets not fret earlier?
That is the problem with investors. They process information non-linearly and in discrete lumps. They do not process it as soon as it becomes available. Further, the weight they attach to the information abruptly changes from inconsequential to earth-shaking levels and vice versa. In the short term, this is what induces a lot of noise and meaninglessness to asset price movements.
Over the very long term, nature asserts itself. Jeremy Grantham puts it well in his latest quarterly newsletter (“What a decade!”), while explaining why the decade of 2000-09 delivered negative returns: “It’s an awfully normal world we inhabit, in the long term. It’s only the short-term zigs and zags that drive us all crazy…”
In contrast to his realism, Bill Miller of Legg Mason thinks US stocks are not expensive. He says so explicitly in his January commentary: “Ten years ago, stocks were expensive; now they are not.”
Grantham disagrees with him. He argues that the decade of 2000-09 ended with the Standard and Poor’s (S&P) 500 not trading at cheap valuations, but expensive valuations (only slightly less so) because it started at very expensive levels. It started the decade in January 2000 at 35 times earnings. It ended the decade at close to 20 times. Therefore, there is no guarantee that stocks would generate positive returns this decade as they had done after every negative decade.
Between 2000 and 2009, S&P 500 stocks generated a total return of -9% (after accounting for dividend payments). In index terms, the loss was -24.2%. All of it, before accounting for inflation!
Robert Shiller calculates cyclically adjusted price-earnings multiples for S&P 500 stocks. He calls it CAPE. The denominator is not just earnings over the last one year, but over 10 years, and both prices and earnings are adjusted for inflation. In other words, it is real prices and average real earning over the last 10 years that give you his CAPE. The nice thing is that his Excel file is available for download with graphics. One can verify his calculations.
His work prompted him to warn Alan Greenspan of a bubble. The CAPE ratio for S&P 500 stocks was 25 and rising. In December 1996, that made Greenspan wonder aloud if stock markets were irrationally exuberant. He withdrew that remark in the face of widespread Congressional and industry disapproval. The fact remains that for the next three years (1997 to 1999), the S&P 500 remained overvalued (and quite significantly so) by the CAPE measure. Shiller was ignored.
Despite that one episode when overvaluation did not lead to negative returns over the subsequent one-three years, we do not know the average 12-, 24- and 60-month return for the S&P 500 whenever CAPE exceeds 20 times, in its 130-year history.
Many are hoping that we have a repeat of the 1990s. That boom was based on genuine technological advancement. It is a different matter that only very few shareholders benefited from it. Many lost money eventually. But it felt good while it lasted. Long-term consequences be damned.
I, for one, am sceptical that we are going to have another technology-based boom/bubble soon. In the worst of times, investors have to brace for asset price erosion at least in the first half of this decade. In the best of times, they can hope for a repeat of the 1970s.
In the 1970s, the S&P 500 delivered a cumulative nominal return of around 18%. Adjusted for inflation, it turned into a loss of 42%. Since dividends were substantial, one could say that the dividends offset inflation and the nominal return of 18% over a decade held. The bad news is that dividend payments are small now. The message that shareholders must carry to managers is clear: Pay us and stop paying yourselves.
Where does this leave Asia? Has the widely expected decoupling arrived? Or is it a chimera as Chimerica has turned out to be? We will explore that next week.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org