Value of markets

I showed in my previous blog that the ratio of depreciation to operating profits is much higher in the published figures for Japanese non-financial companies than it is for their US counterparts and that this could not be justified in terms of either the amount of equipment that needed to be depreciated or the rate at which it should be written off. There is therefore a strong implication that Japanese profits are understated relative to US ones, but this is subject to two provisos.

First, even if the ratio of depreciation to output should be the same in both countries, the ratio of operating profits could be very different if US companies had much higher ratios of profits to output than Japanese ones. 

In two earlier blogs I explained why the cyclically adjusted price earnings yield (Cape) could not sensibly be applied to valuing Japanese shares. (One of several reasons is that Cape is only valid if profit margins are mean reverting over relatively short periods of time, such as 10 years or so, and this has not been the case in Japan.) This does not mean that they cannot be valued by other means. In this and the next blog I attempt one possible way to do this. 

In my previous post I showed why it seems likely that profits published by US companies are currently overstated by much more than they have been in the past. This does not necessarily mean that the degree of overvaluation of the stock market shown by cyclically adjusted price-earnings ratios is understated. The profits as published have been far more volatile than shown in the national accounts, and it is probable that published profits were heavily understated in 2008, as earnings per share in Q4 2008 were negative, while those shown in NIPA Table 1.14 remained strongly positive. 

Chung Sung-Jun/Getty Images

  © Chung Sung-Jun/Getty Images

The profits published by US companies are defined in a very different way from those published in the National Accounts (NIPA Table 1.14) and in recent years they have increasingly diverged.

Those published by companies have become even less “honest” than they used to be. This is the result of the much greater incentives for management to alternately over- and understate the “true” profits, and the much greater ability to do so.

The massive rise in bonuses paid to managements, which depend on the data the companies publish, has encouraged companies to boost profits in the short-term as bonuses often depend on short-term changes in earnings per share or return on equity. Even when they are more directly related to changes in share prices, these often respond to similar changes in the published data. Parallel with this rise in incentives to misrepresent profits has been an increasing ability to do so, with the change from “marked to cost” to “marked to market” accounting.

The result might be compared to the increase in theft that we might expect if windows and safes had to be left open by law, and items stolen were declared to be the lawful property of the thieves. 

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. 

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. 

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. 

“Janet Yellen, the Fed’s head, rather bizarrely used the prospective price/earnings ratio, one of the weakest of all measures, to justify a statement that Wall Street was not overvalued. (This was doubly strange since her husband, George Akerlof, co-wrote a book with Robert Shiller, who has championed a much better measure…” I quote from a recent Buttonwood column in The Economist.

Calling Ms Yellen’s comment “strange” seems very kind. Many people would rate the use of bad data in preference to better as irresponsible rather than strange, particularly when it carries with it the authority of the US Federal Reserve

In my last blog I emphasised the importance of foreign investors for the Tokyo stock market, but suggested that their future behaviour was either unpredictable or momentum based. If the latter assumption is correct, foreigners are likely to amplify rather than lead changes in the market’s direction and to assess its prospects we therefore need to look at the other participants. 

When a central bank buys government bonds, the liquidity of the sellers rises. In the absence of changes in liquidity preference, this will drive the sellers to buy other assets, in particular non-government bonds and equities. Unless the supply of the alternative assets increases, the buying will push up their prices.