April 6, 2010Now that the sharp rebound in the S&P 500 last year has been followed by relatively weak performance thus far in 2010, it is tempting to believe the “easy money” has been made and the equity market is poised to resume 2008’s downward trajectory. Even though the S&P 500 P/E multiple, at 14.5x this year’s earnings, remains below its long term average, many investors are still bruised by excessive equity exposure in 2008 and are looking to take profits. Our analysis in the fourth quarter of 2009 suggested that equity valuations looked reasonable, and that they incorporated a healthy risk premium compared to history. Since then, we have collected another quarter’s worth of earnings data and refined our observations about the market. At this stage, it is abundantly c lear that stocks have much better fundamental earnings support than they did in mid-2009, when profits were still in a downward spiral. Now, thanks to the benefit of a massive cost retrenchment on the part of corporate managements, 2010 S&P 500 earnings per share are projected to be $75-80 and stocks look somewhat cheap, particularly after the recent sell-off. Still, it appears that many have capitulated on stocks and active management in particular. We are troubled by the volume of money flooding away from active strategies into passive indexing and ETFs; it has been said there is no asset class or investment strategy that too much money cannot destroy. ETFs and other passive strategies are now at front and center of the money flow, with commodities and alternatives close behind. Indexing has received a huge boost from a 20-year bull market in interest rates, and falling rates have been a major factor in supporting P/E multiples. But now monetary policy is “zero bound” and strategies that capitalize on expanding multiples face serious headwinds. Our view is that while stocks continue to offer upside as earnings normalize, there is low probability that gains will be driven by expansion in P/E multiples, given pressures on equity discount rates, constraints on top line sales growth, and the inability of corporations to drive margin expansion through further cost cutting. Who Is Winning The Active/Passive Debate? The active vs. passive discussion is especially timely at this juncture. Earnings achievability is now crucial and the punishment exacted for missed earnings will be significant. We think that active management makes more sense than simply buying “cheap beta” through passive index strategies, given the environment where headline market returns will be capped by interest rate pressures and growth constraints from deleveraging. Correlations across asset classes, industries and individual stocks rose dramatically during the sell-off in 2008 and early 2009 because most financial assets were for sale at the same time, driving all prices down at once. Now, as some rationality returns to the markets and macro considerations are declining in importance, company-specific fundamentals will re-assert their significance in the pricing equation, leading to return dispersion within industries and sectors and giving an edge to stock-picking strategies. The market’s recovery from its “near death experience” in March 2009 has produced several significant price dislocations of which investors need to be aware. Quality looks cheap. Higher quality businesses with less volatile earnings carry attractive multiples and high implied rates of return compared to lower quality stocks; they embody a greater margin of safety compared to growth-dependent shares that require stable interest rates and further positive earnings surprises to justify high expectations built into their relatively rich valuations. Growth strategies are usually based on the need for P/E multiple expansion and/or some positive momentum. Growth outperforms leading into a recession; it is helped greatly by falling interest rates as the Federal Reserve makes monetary policy more accommodative. This is because stocks are “long duration” assets; shares of growing companies that reinvest heavily have especially long durations since more value derives from long-dated cash flows (in contrast to slower growing firms that generate high free-cash flows with more shareholder value front-loaded in the way of dividends or share buybacks). Hence, growth shares benefit most when interest rates are falling at the outset of a recession. But when the economy begins to recover, monetary policy becomes more restrictive and rates start rising, value shares outperform; their lower multiples and front-loaded cash flows imply shorter durations and less interest rate sensitivity. This partly explains why we think value strategies are now poised for an extended run of strong performance. A Closer Look at the P/E Multiple In both theory and practice the calculus of pricing stocks boils down to three key fundamental variables: 1) expected cash flows, 2) future growth and 3) the interest rate at which the anticipated earnings stream is discounted back to present day value. Investors make a collective assessment of these factors, distilling them down to a single expression that captures expectations of all three: the P/E multiple. All things being equal, the fair value P/E increases with expectations of profits and growth, and falls in response to higher interest rates and risk premiums. (See Figure 1). Figure 1
The P/E multiple can be applied to various profit measures (e.g. normalized earnings, forward earnings, historical profits) but the objective is the same: to estimate fair or “intrinsic” value of a single stock or the market as a whole. [1] [1. End Note: Because practitioners differ in the earnings measure used in the denominator of the P/E ( e.g. operating EPS vs. reported EPS, historical vs. forward, normalized vs. current period), we will use a range for P/E when referencing historic multiples] In the short run, P/E multiples expand and contract with temporary or cyclical movements in the earnings denominator. Over time, however, the trend in multiples and the general market direction is dictated by investors’ overall assessment of normalized earnings power and growth prospects, and the rate at which investors discount these. What sets earnings and growth forecasts apart from the third key variable in stock valuation, the discount rate, is that historical earnings and growth can be directly measured and used as a basis for setting expectations for the future. The discount rate, in contrast, is unobservable since it can only be inferred by triangulating between earnings, growth and current market prices. [Once a measure of the discount rate is inferred, it is split into two parts: the rate of return earned on riskless assets (i.e. Treasury notes) and a residual risk premium required by investors to bear equity risk.] Rather than make long-term forecasts for the factors that directly influence equity valuations, our approach is to assess what assumptions are implicit in stock prices, decide whether the embedded forecasts are directionally too high or too low and carefully gauge the balance of risks should we be proved wrong. Investor forecasts usually entail an explicit or implicit bet on P/E multiple expansion or contraction, driven by some combination of changes in the three pricing variables. The great bull market run that began in 1995 culminated in 2000 in a peak S&P 500 P/E multiple of 30x to 40x, a historical extreme fueled by lofty growth expectations of the “New Economy,” as shown in Figure 2. Figure 2
The market was further pumped up by a collapse in the required risk premium, as greed trampled fear in the investor stampede for soaring internet shares. Market multiples began to deflate early in 2000, pressured at first by six Federal Reserve rate hikes and a 200 basis point rise in market yields, then by economic retrenchment, falling corporate profits, and finally by tempered growth expectations, once investors recognized that the surge in IT spending leading up to Y2K would prove temporary. The Lost Decade Starting valuation is the biggest factor influencing future stock returns, and the sky-high 30-40x multiple in 2000 led to a cumulative 10-year total return for stocks of about -10%, as the P/E multiple collapsed due to rising yields and lower growth, reaching a multi-decade low of 9-10x in March 2009. Over this decade, earnings, growth and discount rates conspired to drive P/E multiples lower in several phases. Between 2000 and 2002, lower earnings and a multiple contraction from 30x to just 15-20x drove the S&P 500 50% lower, even as the discount rate on earnings remained relatively stable. From 2002 to 2007, S&P 500 earnings per share exploded, rising at an annualized 18% clip, from $ 38 in 2002 to $92 in mid-2007, as shown in Figure 3. Figure 3
As expectations for normalized earnings moved up, market P/E multiple expanded by about five points to 25x. From 2007 to 2009, earnings multiples resumed their downward path, triggered by nine quarters of successive earnings declines which pushed the S&P 500 EPS from $92 down to $39, a fall of historic depth and duration. Falling earnings and lower growth were compounded by a spike in the equity risk premium (ERP) demanded to hold stocks. By our measurements, the ERP increased from about 3.5% in 2006-2007 to over 8.5%, coincident with the market bottom in March 2009. In recent months, 2010 EPS estimates for the S&P 500 have moved to about $75-80, which represents a 15% return on equity (ROE), roughly in line with estimates of longer-term normalized earnings power for the S&P. Currently moving in a range between 1050 and 1100, the S&P trades at 14-15 times 2010 EPS estimates. With this in mind we make the following assessment of the potential for multiple expansion, based on the three key variables: discount rates, growth and earnings. Discount Rates: Neutral. We are now at a crossroads with monetary policy “zero bound” and unable to push benchmark interest rates lower, while fiscal policy responses to the financial crisis, heightened federal financing needs, and awakening inflation expectations are all exerting upward pressure on yields. While the likely outcome of higher interest rates is already reflected in forward rate expectations, there is considerable room for the ERP to contract, since at 6.50% it remains nearly twice its average over the past 130 years. Historically, the ERP is negatively correlated with Treasury yields, since early to mid-stage economic recovery triggers higher interest rates, but also represents a more favorable environment for corporate earnings growth. On balance, the prospect for P/E multiple expansion due to declines in the discount rate is unlikely, since decreases in the ERP will likely be offset by higher yields, resulting in a steady equity discount rate of around 10%. [2] [End note [2]: The 10% implied discount rate embedded in stocks translates into a “buy and hold” compound rate of return on equities of 10% which in our opinion is attractive on an absolute basis and compared to other asset classes] Growth Rates: Neutral to negative. Historically, earnings growth for companies that comprise the S&P 500 has averaged about 7% per annum. By our calculation, a nominal earnings growth rate embedded in equities is currently about 5%, (2.5% real growth and 2.5% inflation), nearly one-third less than the historical average. Corporations have already slashed overhead expenses, working capital and expenditure on plant and equipment, leaving companies with considerable operating leverage to grow profits, should aggregate demand and top-line revenue growth revive, but with little incremental room to cut expenditures further if revenues stay sluggish. With unemployment stubbornly high and consumers retrenching through lower spending and increased savings, domestic consumption remains a long-shot bet as the engine for future growth. Export demand, combined with inventory restocking requirements, could fuel some growth but both these factors are transient and volatile. The more likely source of growth is a recovery in business investment which would trickle down to employment and spending. Nevertheless, the consumer remains the nuclear reactor of the economy and the constraints on employment, incomes and spending make it likely that overall growth in demand, revenues and profits will be lower than in the past. Earnings: Neutral to Positive. In March 2009 the path of earnings warranted an S&P 500 of 600 to 700, as earnings plummeted from their $92 peak in mid-2007 to $39 in late 2009. The upward launch pad for the market was set in the same month as investors correctly sensed that earnings would reverse their downward trajectory from the peak they attained in 2007. Today, many argue that the rebound in the market has left it overvalued. We disagree. After three solid quarters of rebounding earnings, the market has much better fundamental support and expectations for $76-$80 for 2010 certainly justify an S&P in the 1100-1200 plus range. As noted, this level of the S&P still implies a 10% long-term compound return on stocks. However, with P/E multiple expansion unlikely to be driven by declines in the discount rate, and growth expectations capped by consumers’ need for higher savings and debt reduction, the market’s path over the next 12 months will depend on earnings achievability. Investors of all stripes will need to have a sharp pencil and a weather eye on corporate sales and profit margins during that time. Corporations have so far delivered the goods as fourth quarter reported earnings have come in above expectations and the ratio of companies recording positive surprises versus disappointments are running at nearly 4 to 1. In this environment the overall market might be described as directionless, range-bound or characterized by large one-day moves in either direction. However, sideways movement at the overall market level masks a significant dispersion of returns at the individual stock level, and this is where active management can and should produce strong results In conclusion, many have said that the psychological damage to our equity culture resulting from the market’s rout is permanent. Analysis of this kind is not within our jurisdiction and we leave it to economists and behavioral finance experts to ultimately make that determination. As investors, we are interested in looking at the likely path of earnings, growth and discount rates and their influence on P/E multiples as well as the future direction of the market. At this juncture, the headwinds against multiple expansion are considerable and this stacks the balance of risk in favor of active stock-picking strategies that maintain a strong valuation bias. Higher quality large cap stocks should also be emphasized, since the rally off the bottom has favored lower quality names, leaving the larger names with more attractive upside. (c) Robeco Investment Management
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