Equity and bond markets

Investors rightly worry about the risks they run as well as their prospects for gain. The assessment of risk is complicated because for equities it varies over time. Holding a balanced portfolio of shares becomes less risky as years go by. While there is always a possibility of bad outcomes, if equity returns were random such risks would fall over time. But in practice they fall even faster because returns are not random but show “negative serial correlation”, which means that after periods of above average returns the chance of below average ones increases and vice versa.

No one would own equities if they didn’t expect them to give positive real returns. As they have in the past it is reasonable to expect them to do so in the future. If markets fluctuated in a random way, the most likely return in the future would be their long term past return which in real terms has been around six per cent per annum. Read more

Japan’s economic policy is a battle between those who want inflation, on one side, and the fiscal hawks on the other. Prime Minister Shinzo Abe’s decision to hold a snap election suggests that the inflationists, of which he is one, are currently winning. The market rose on the news of the election, so it seems that investors believe that inflation would be good for both share prices and the economy.

Inflation, as measured by annual changes in the consumer price index, is currently well over 2 per cent. But according to the Bank of Japan, prices for producers are actually falling relative to three months ago, after the effects of this year’s consumption tax increase are excluded. The central bank goes on to state that this is a reflection of declining prices for international commodities, and that the annual rate of increase for consumer prices is just 1 per cent after fresh food is removed from the calculations. Read more

Hedge funds’ portfolios are often leveraged and they can be big winners or losers if this pays off. In this sense the US is also a hedge fund. In terms of its international assets, the US is long equities and short debt. This has been hugely to its advantage because equities have given much better returns, but this benefit carries large risks for the future.

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The damage done to the UK and US economies by buybacks in preference to capital investment was a central theme of my book The Road to Recovery, and it has found its way, not too often I hope, into these blogs. I have therefore been heartened by the growing interest shown by the financial press in this threat to our economies. The Economist recently devoted a major section to the issue, as did the Financial Times on October 12.

The change in the way managements are paid drives buybacks but this has yet to be widely appreciated. The US Federal Reserve’s quantitative easing programme was rightly underlined by my colleagues as adding the fuel of cheap debt but, without the preference for buybacks, low bond yields would have encouraged capital investment. This they markedly failed to do. An important paper, shortly to be published in the Review of Financial Studies, “Corporate Investment and Stock Market Listing: A Puzzle?” by John Asker, Joan Farre-Mensa and Alexander Ljungqvist demonstrates that a huge difference has appeared in recent years in the levels of investment by quoted and unquoted companies. Read more

Asset prices fall if investors’ liquidity preference rises or if their liquidity falls (ie, if investors need the money or want to have more cash in their portfolios). Liquidity depends on central banks; they can create it or soak it up. The US Federal Reserve seems unlikely to reduce liquidity unless inflation picks up, but is likely to stop creating it in October. Therefore, one way in which asset prices will fall is a rise in inflation or pre-emptive action by the Fed to stop it.

When the Fed creates liquidity, it takes a larger rise in liquidity preference than before to hit asset prices. The Fed is thus in the process of increasing the market’s sensitivity to rises in liquidity preference and, as small changes are the normal response of investors to new information, the volatility of the market is therefore likely to rise. In the absence of increased interest rates, large changes in liquidity preference, however, are likely to depend on falling profits. Read more

In a comment on my recent blog regarding the equity risk premium, “Le gun” asked for a guide to making long-term investment decisions and I promised to try.

In 2009 TengTeng Xu and I addressed this issue in a paper called “Investment and Spending Strategies for Endowments”. We were specific because the need for income and the investor’s time horizon should both be taken into account when deciding on a sensible policy for individual investors. We considered the use of only three asset classes: equities, long-dated bonds and short-term deposits (cash). We did not include property because we were unable to find suitable long-term data and dismissed commodities, including gold, as combining poor returns with high volatility. With regard to the possible portfolios, we came to several conclusions which I will adapt here for all long-term investors, rather than just endowments. Read more

Ed Balls, who has a high chance of being the UK’s next chancellor of the exchequer, has announced that the opposition Labour party is “examining the case for introducing an allowance for corporate equity, to redress the systemic bias in favour of debt finance”. This would be very sensible, but it needs to be done sensibly.

Allowing interest as a deduction before calculating the profit on which corporation tax should be paid encourages excessive debt, buybacks of equity in preference to long-term investment and debt-financed takeovers. The views of economists on its undesirability are one of the few instances on which they are almost all agreed. It is one of the rare exceptions to the old rule that “n economists = n+1 opinions”. Read more

In some of my more gamesome moments I have challenged my students to produce an article about the equity risk premium, which made a useful contribution to our understanding of the way financial markets work. So far the challenge has not been met. This may reflect the modesty and good manners of those I teach but also, I hope and believe, the fact they are too sensible to wish to defend the way this often ill-defined and generally useless concept has been habitually discussed. In practice, comments on the ERP seem to me to have been a source of confusion and error rather than illumination.

The ERP can be defined in at least two ways. One is the historic difference between the returns on bonds and equities and another is the expected difference in these returns. Alternatively, the “risk-free rate” can be used in place of bonds. Read more

A few weeks ago, I promised to write about claims that the stock market could be valued by comparing earnings yields to bond yields. This approach is sometimes called the “Fed model”. This was fashionable in the 1990s and seems to have some followers even today. It is not only nonsense but is the most egregious piece of “data mining” that I have encountered in the 60-plus years I have been studying financial marketsRead more

While it is sometimes useful to make a distinction between treasuries and central banks, they are fundamentally both part of government. When central banks buy bonds as part of quantitative easing, governments are in practice ceasing to fund, ie, they are issuing short-term rather than long-term debt. If this is potentially harmful, we need to worry; if not, we need to ask why have governments funded in the past? Read more

The US seems expensive relative to other major stock markets. As it is probable that cheaper markets will give better returns, this implies that investors should underweight US equities. This conclusion applies, however, only over the longer term. Timing matters and this involves other considerations.

Chart one illustrates that G5 stock markets are strongly correlated with the US and so, to a large extent, markets go up and down together. The chart also shows that this tendency has been strengthening over time. Read more

Cyclically adjusted price-earnings ratio (Cape) appears to be a valid way to measure the value of the US stock market, but this does not mean that it can sensibly be used for other indices. As I explained in a previous blogpost, Cape is only valid if it can pass two tests: first, that the real return on equities has been mean reverting; and second, that profit margins have also been mean reverting and have rotated quickly around their average.

Real returns on equities has been less strongly mean reverting in other markets than they had been in the US. This weakens the case for Cape in other major stock markets, but does not, I think, necessarily rule it out. Even if returns would otherwise have been mean reverting, they will not have been if countries had suffered unexpected and catastrophic losses, such as occurred in world wars. I had already explained in Growth and returns, another blogpost, that these losses were the probable explanation for the exceptionally low returns on equity investment in the first half of the 20th Century in countries such as Germany and Japan. Read more

The cyclically adjusted price-earnings ratio (Cape) has become well known as a way of valuing the US equity market. Its moderate success in this role has led to the assumption that the same approach will be valid for other markets. Unfortunately this seems doubtful, as I will try to explain. I should warn readers that, despite trying to make my explanation as simple as possible, I have been unable to avoid raising some quite technical points.

There are two fundamental and very different ways in which equity markets can be measured. One of these is q, by which the market value of companies is compared to the real value of their assets. This follows from the basic principle that, in any reasonably competitive economy, the value of anything depends on the cost of creating it — and it is therefore the macroeconomic approach. The other way treats equities as financial assets and values them by discounting the expected future returns at an appropriate rate. Cape is based on this approach and depends for its validity on the data for any particular stock market being consistent with the theory behind it. Read more

I wrote in an earlier blog that I would become more cautious about US equities if profit margins came down. We have just had the figures for the first quarter of 2014 and profit margins have narrowed. I should therefore keep readers up to date and explain why I do not think the latest data are signalling the top of the market.

As I pointed out in “US corporate debt and cash flow”, US companies have been the key buyers of the stock market and the rate at which they have been buying shares is unsustainable, because debt cannot continue to grow at the pace needed to finance the purchases. The difficulty with things that cannot go on is deciding when they will stop and I will try to explain why I think this point has not yet arrived, despite the uncertainty that anyone must have about such things.

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Capital should flow to the places where the best returns are expected. If this were to work in practice as well as in theory, we would find that industries and countries which are expected to grow rapidly should give no better than average returns.

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It is common to read claims that “US companies’ balance sheets are in good shape”. But, as I showed in my last blog, the most recent data we have showed that that “non-financial business” debts on balance sheets were at record high levels in the fourth quarter of 2013 relative to gross domestic product. I hope that readers will be interested in a necessarily quite technical explanation of why misinformation seems so prevalent about corporate leverage.

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In my first blog post “US equities are overvalued” on February 17, I wrote: “My own view, which is only an opinion and not a factual observation like the q and cyclically adjusted price/earnings ratio data, is that the two main driving forces which have pushed the stock market up are still operating. These are the strong buying of shares by companies and the impact of quantitative easing. I plan to write about these soon in this blog.”

I showed in my second post – “US equities: more buyers than sellers” on February 20 – that companies were the main buyers of US shares and that I expected this to continue; I am now turning to QE. Read more

The financial information published by companies has become increasingly bogus in recent years, because of the huge incentive for modern management to produce highly volatile profits. This has been helped by the increased flexibility allowed with the change from “mark to cost” to “mark to market”.

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If investors wish to buy more than others wish to sell, share prices will tend to rise. It is therefore sensible to look at who buys and who sells and if any changes seem likely.

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US equities are dangerously overvalued, being around 70 per cent above fair value (see chart).

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