A 40% drop?

Barron’s magazine published an article in this week’s issue : A Skeptic’s View of the Trump Rally – Dreyfus Global Real Return manager sees stocks falling 40% or more once long-term trends reassert themselvesThe article expresses the view of fund manager Suzanne Hutchins. I agree with her, although I don’t necessarily see such a drop in stock prices as imminent.

The number 40% reminds me of a simple calculation I performed in my mind recently. The Shiller PE ratio (inverse of the earning yield) of the US stock market reverts to its mean in the “long-term”. The long-term mean for the Shiller PE ratio is 16.7. Right now, the Shiller PE is at ~28. A return to historical mean would imply a drop of (28-16.7)/28 = 40.4%. That’s pretty close to the 40% number in the article.

shiller-pe-87cab6b279fa9ea8

There are many other considerations though.

First, in the language of statistics, the distribution of the Shiller PE ratio isn’t stationary. It demonstrates trends lasting decades. Its mean is strongly influenced by interest rates among other factors. In a low interest rate regime, considerations of opportunity cost would induce the Shiller PE to remain higher (stocks would maintain a lower earning yield) than its long-term mean. This has happened in recent decades thanks to an extended low interest rate environment. So, one could question the premise that the Shiller PE would return to its long-term mean. It isn’t hard to see from the chart above that recent decades have supported average Shiller PE values above 20. A drop from 28 to 20 is a big drop, but closer to 30% instead of 40%.

Second, when the market crashes, it doesn’t crash to the mean of historic patterns, it usually overshoots, i.e.,  crashes further down, so a large crash can be expected.

Third, major market crashes begin in anticipation of recessions, and the market hits bottom often when the recession in underway. In a recession, earnings are lower than in boom time e.g. today. Doing the math, if the PE ratio were to go down to its historic mean of 16.7 during a recession when earnings were, say 25% lower than they are now, then we would see a market drop of 55% from present levels.

Finally, and worth repeating: while I see such a drop as probable, I don’t necessarily see it as imminent. In the last two major market crashes 1. post the dot-com bubble, and 2. post the housing bubble, the market crashes were predicted and anticipated by many, but the decline did not start until long after people started predicting it. Signs of economic stress were felt for years even though the market did not crash. The St. Louis Fed publishes a Financial Stress Index, which is a composite of several indicators of economic stress (below).

fredgraph

Looking at the chart above tells us that stress levels were above zero since 1994 even though the market, driven by euphoria, went to bizarre highs all the way to the end of the 1990s. And post the housing bubble, although stress started to spike up in late 2007, the big crash only happened in late 2008. Right now, the stress index reads negative (i.e. low stress), and not just barely negative but its value is easily in the bottom quartile of values since 1994. The economy is doing fine. That’s one reason why I don’t see a crash as imminent.

Of course, there’s always the risk of unforeseen events (e.g. natural or manmade catastrophes) or harebrained policy actions triggering market collapses prematurely.

Of tenbaggers and 100 baggers

A tenbagger is an investment that grows tenfold. A 100-bagger is – you guessed it. I recently read a book with the title 100 Baggers: Stocks That Return 100-to-1 and How To Find Them. I save such books for long flights. 🙂

Searching for tenbaggers or 100-baggers isn’t a substitute for a sound investment plan, but the book highlights the importance of being patient with investments. It is extremely hard to predict which stocks will do the best in the long run. Taking quick profits is a sure way for an investor to ensure that none of his/her positions will ever grow very big. My words lack the eloquence with which Peter Lynch said it in his book One Up On Wall Street:

“The point is, there’s no arbitrary limit to how high a stock can go, and if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock. Shame on all those experts who advise clients to sell automatically after they double their money. You’ll never get a ten-bagger doing that.

Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is.”

Sage advice from an all-time investment great. According to Wikipedia, Lynch averaged a 29.2% annual return between 1977 and 1990, more than doubling the S&P 500 market index.

The author of 100 Baggers suggests an alternative he calls the “coffee can” method. The name is a throwback to a time when stocks were paper certificates. The idea is to stuff certificates into a coffee can and store it in a place where it will stay forgotten for years – quite the opposite of the “online brokerage” method where we can watch the fluctuations of our wealth all day long.

The outcome of the coffee can method is pleasantly often the following. Most stocks do unremarkably, but a few do reasonably well, and one does extraordinarily well making the returns of all others look paltry by comparison. The book has some entertaining anecdotes revolving around this theme.

Attractive global returns for the patient investor

We talked about earnings yield in Where should I invest?. When it comes to stocks and stock markets, the Shiller PE ratio (also called the CAPE ratio) is a good way to measure earnings yield:

Estimate of earnings yield = (100 / Shiller PE ratio) %

Higher the CAPE ratio, lower the earnings yield. For a long-term investor, higher earnings yield is obviously more attractive. In a number of works published in the 80s and 90s, e.g., Stock prices, earnings, and expected dividends, researchers illustrated that high stock market earnings yield is generally followed by good market performance and vice versa.

One point worth noting is that Shiller PE is not very good for predicting short-term returns or for timing market crashes. The predictive ability improves when the forecasting period is longer, e.g. 5 or 10 years. This has been demonstrated, e.g., in the paper Dividend yields and expected stock returnsA high Shiller PE (low earnings yield) generally means that a country’s stock market is overpriced, and investing in that country will probably lead to disappointing results eventually. However, it does not guarantee that the country’s stock market will do badly next month or next year. A richly valued stock market can continue to become more richly valued for several years, eventually turning into a stock bubble before it crashes. This happened in the late 90’s when the US stock market became heavily overpriced, a phenomenon attributed to irrational exuberance.

Investing in a basket of countries with low Shiller PE ratios generally leads to higher returns, a result demonstrated convincingly in a number of publications, e.g., the paper Global Value. Conversely, countries with high Shiller PE ratios exhibit poor returns over the subsequent 10-year period.

Shiller PEs and other country stock market valuation metrics are posted quarterly on Star Capital. They recently posted an update showing that performance of stocks in different countries corresponded well with their Shiller PE based predictions in 2016. Russia, the country with the lowest Shiller PE posted returns of 37% (in ruble) and 58% (in US dollar) in 2016. Russia doesn’t sound like a safe place to invest. And that’s generally true of countries with low Shiller PE ratios. CAPE ratios in the neighborhood of 5 signal extreme distress or significant risk factors. Risk factors include the risk that foreign investors may lose all their money or that a country’s currency may go to zero. However, such terrible outcomes are rare enough that investing in a diversified basket of cheap countries produces high returns with high probability in the subsequent 5-year period. While it is no doubt daunting to invest in such countries, I remind myself that historical studies take into account periods of far greater uncertainty than today, including World Wars where most countries were direct or indirect participants.

As of the day of this posting, the US stock market is quite expensive with a Shiller PE of around 28. This is just under double the historic mean and median of around 16. However, this doesn’t mean that a market crash is imminent. I’ve provided one reason above – that overvaluation is a poor market timing instrument. There’s also another reason having to do with opportunity cost, an idea labeled as the equity risk premium. The Shiller PE corresponds to a 10-year average earnings yield for stocks, and I find it helpful to compare this with the 10-year treasury rate. Since stocks carry much more risk than treasuries, it is reasonable to expect that the earnings yield of stocks will be higher than the treasury yield to compensate for the higher risk, the difference of the two being the equity risk premium. In 1929 before the great depression, and in the late 1990’s before the dot-com bust, the 10-year earnings yield of stocks  went lower than the 10-year treasury’s yield, signaling extreme overvaluation. The US stock market has an earnings yield of 100/28 or about 3.6% now. This is clearly still higher than the yield of the 10-year treasury, currently at 2.4%. The difference gives us a roughly calculated equity risk premium of 1.2%, low by historical standards but still positive. In other words, high stock valuation is being supported by low interest rates. If the Fed were to raise rates rapidly, stocks would start to look less attractive, but we’re not there yet.

A note for those who follow the SciPre portfolio: Many countries in the SciPre portfolio have low Shiller PE ratios. Their undervaluation is an important factor contributing towards their inclusion in the portfolio.

SciPre Portfolio : Jan 1, 2017

Here’s what the SciPre portfolio looks like as of 1/1/2017.

Asset class Ticker Allocation
Australia stock EWA 5.0%
Brazil stock EWZ 5.0%
Chile stock ECH 5.0%
Egypt stock EGPT 5.0%
Emerging Markets local bond EBND 10.0%
Emerging Markets USD bond VWOB 5%
Global value GVAL 5.0%
Gold GLD 5.0%
Gold miner stock GDX 5.0%
Greece stock GREK 5.0%
Hong Kong listed China stock FXI 5.0%
Intermediate-Term Corporate bond VCIT 5.0%
Italy stock EWI 5.0%
Nigeria stock NGE 5.0%
Poland stock EPOL 5.0%
Russia stock RSX 5.0%
South Korea stock EWY 5.0%
Spain stock EWP 5.0%
Turkey stock TUR 5.0%
Total 100.0%

First things first. I do not recommend this portfolio to anybody. Each individual’s risk appetite is specific to that individual, and one portfolio could not possibly serve all.

Second, the SciPre portfolio combines ideas of valuation and diversification across asset classes and geographical regions. I have put much thought into the design of this portfolio. However, allocations are deliberately simplified. Future posts will illustrate many of the ideas that went into this portfolio’s construction.

Finally, the tickers are usually those of ETFs that serve the mentioned asset class. I include tickers so that the perfomance of the SciPre portfolio can be tracked. I am not recommending these specific ETF products. In each asset class, there may be mutual funds and ETFs that have lower costs or more desirable features.

Disclaimer: The opinions expressed here are mine alone. I am not offering advice or recommending any product. I may own some of the asset classes and tickers mentioned above, but may not own others. Consult your financial advisor befor making financial decisions.

The SciPre portfolio

Starting Jan 1, I will post a portfolio of financial assets – stocks, bonds, mutual funds, ETFs etc. – on this blog.

The portfolio will be based on principles of global asset allocation, combined with my understanding of valuation. The portfolio will be investable. I will deliberately keep the portfolio’s composition simple.

The portfolio will be updated quarterly i.e. on April 1, July 1 and Oct 1. I may update in between these dates if markets move sharply, but this should be relatively rare.

SciPre renamed SciPre

When I started writing this blog, the name SciPre was short for Science of Prediction. But investing is very little prediction. Predicting markets, such as the timing of crashes, is extremely hard to pull off with any consistency. To quote Warren Buffett: “The only value of stock forecasters is to make fortune-tellers look good.”

Rather, investing is a lot of preparation, and in times of risk… preservation. There’s an element of prediction too, but it’s a small piece. I was on a flight last night when I decided to rename my blog from “SciPre – Science of Prediction” to “SciPre – Science of Preparation”.

Where should I invest?

Should I invest:

  • In a bank account?
  • In a home?
  • In stocks?

This question has no simple answer, but it has an answer. Moreover, it is possible to simplify the key elements of that answer. This post is about explaining how different investments can be compared. A word of caution. It is said that a little knowledge is a dangerous thing. It is not the “knowledge” that is dangerous. When a little knowledge brings with it a great deal of “confidence”, that overconfidence can cause a person to take outsized risks and ultimately bring misfortune. Bear in mind that what I say here is a deliberately simplified answer to a difficult question.

Let’s start with the bank account, as this is the simplest investment. Let’s say you put $100 into a savings account in a bank, and the bank pays a 2% interest rate. The $100 is called your principal, and the $2 you will earn in a year is the return on your principal. The chance that you will lose your principal ($100) is small. It can happen, e.g. if the bank shuts down and your account is not backed by the government, but this happens rarely. In the United States, the FDIC protects investors against loss of deposits from bank failure to a significant extent.

How does the bank account above compare with a home? Just as we can put $100 into a bank and earn interest, we can similarly buy a home and earn rent. A two-bedroom, one-bathroom apartment in San Francisco could cost $1 million to buy and $40,000 a year to rent. The rent-to-price ratio is therefore $40,000/$1,000,000 = 4%. If I had a million dollars in cash, I could buy such an apartment and earn a 4% return in the form of rent. This basic idea is simple. Now, let’s get into the weeds. Unlike a bank account, where the principal is fixed, the value of a home can change. Home values usually increase over time, but sometimes they fall like they did when the US housing bubble burst. There are maintenance costs and a variety of taxes (and some tax benefits) associated with homes. Homes are also illiquid, meaning it is not always easy to buy or sell a home.

How about stocks? A stock or a share represents partial ownership of a company. If a company has one million shares, and each share is worth $10, then the company is worth $10 million, which is called the company’s market capitalization. If this company earns $1 million in a year, then the earnings per share is $1 million / 1 million shares = $1/share. The ratio of earnings to price is called the earnings yield. In this case, it is $1/$10 = 10%. Stocks carry many risks, including the risk of going down to zero, and prices that fluctuate daily. Besides, even though the share in this example has an earnings yield of 10%, that 10% is not paid back to the shareholder. Some part of it (or none of it) may be paid out in the form of a dividend to the shareholder. In the example above, if the company chooses to pay 20% of its earnings (20 cents per share) to shareholders, then it has a dividend yield of just 2%. Some investors attach more importance to the dividend yield, which is what they are being paid “now”, than the earnings yield which is reinvested in the company. This example is over-simplified, but it illustrates the idea that money earns return when invested in a business.

The annual interest rate in a bank account, the rent-to-price ratio of a home, and the earnings yield of a share represent the same idea for different investments – the idea of return on investment.

Going back to what I said about a little knowledge, it would be dangerous if the message you take away is that one can compare a bank account, a home and a share of a company based on their return on investment alone. The risks are totally different, so such a comparison would not be apples-to-apples. That said, I find it helpful to compare investments using their long-term expected return, which is what one might reasonably expect if holding the investment for many years. This isn’t easy to calculate, but great minds (including some Nobel laureates) have worked on it, so it’s at least partially understood. I’ll talk more about this idea in later posts.