Too soon to talk recovery

The dominant mood of planners at the recent FPA Conference was that 2002 was a tough year, but it is important to ensure clients adhere to their long-term strategy and consequently maintain their equity holdings, even if very high. It may be useful to pose some questions about this consensus view.

The same mood prevailed in 2001 — that it was just a matter of time, and not an unacceptably long period of time, for the benign hand of stock markets to reward those who were faithful to it.

The mood a year before that, when markets were still near their peaks in 2000, was dominated by the optimism that characterised the stock market bubble. This attitude was reflected in portfolio construction that saw equity funds receive more than 90 per cent of the industry’s net inflow for the year — a record. More than half of this went into international equities, also a record.

When one asset class attracts unprecedented proportions of portfolios the view must be that it represents a particularly attractive opportunity. Yet there was evidence at the time that international stock markets were particularly unattractive.

This is not hindsight talking — I expressed concern about the level of international stock markets in several earlier articles.

We wrote to our clients in 2000 stating that “the US market could fall by 50 per cent”.

It is useful to note the tools that highlighted the then-dangerous height of the market to see what they are telling us today, ie. to assess whether the prevailing optimism about imminent recovery is justified.

Price/earning (PE) ratios and Tobin’s Q are examined in the graph opposite.

Each has strengths and weaknesses. The weakness with PE is the arbitrariness and short-term fluctuations in earnings. In order to smooth these out I’ll use the average of the last 10 years’ earnings, the method employed by Professor Robert Schiller inIrrational Exuberance.

The graph shows that, in 2000, PEs reached entirely unprecedented levels, suggesting an extreme over-valuation.

Tobin’s Q is an attempt to measure price against asset backing. Measurements of book value, net tangible assets (NTA), and so on, involve as many arbitrary procedures and standards as with calculations of earnings. Tobin’s Q ratio uses data published quarterly by the US Federal Reserve representing its estimate of the replacement value of the assets of corporate America.

Tobin’s Q also suggested that prices were unprecedentedly inflated in 2000.

The graph is a log scale and the zero line is their average level. It is striking the extent to which the two methods have supported each other’s judgements about the relative value of the US market for more than 100 years.

Both exceeded their previous record highs (reached just before the Great Depression) at the peak of the tech boom.

Incidentally, the ratio of market cap to gross domestic product (GDP) also rose to never before seen levels in 2000. Virtually any measure indicated caution was called for, yet this was the year when international equities received their highest proportionate net inflow.

Surely one of the lessons that must be learnt from this is that planners must be aware of what credible historical methods of valuation are telling us at any point in time.

What are they telling us today? PE and Q have only been this far above their average levels on 8 per cent and 22 per cent when talking of occasions since 1883. At first glance this would suggest caution about recovery rather than optimism.

However, inflation is clearly relevant. Common sense suggests that, for example, PEs should be materially higher in a low inflation environment than they were in the 1970s when inflation was in double-digits. However, the question is, how much higher? Are today’s levels reasonable for periods of sustained low inflation?

Quarterly CPI figures are very volatile. Using a smoothed, four-year average inflation measure (two years in arrears and two in advance) suggestsprima facieevidence that higher valuations are justified in lower inflation environments, although PEs have varied between 4.8 and 43.8 when inflation was between 1 per cent and 4 per cent.

Inflation today is around its average, but PE and Q are above their average. Since 1883, there have only been two earlier periods of relatively stable low inflation — from the start of the 20th century to the start of World War 1 and through most of the 1950s and 1960s. In the first period the market generally traded at much lower valuations than today. In the second it traded near today’s valuation level.

If we accept that we would need a significant number of instances before drawing strong conclusions we would have to recognise there is inadequate data to draw conclusions about appropriate levels for the market in sustained low inflation environments.

Thus we are left with two facts. Markets are currently priced above their average, and it is not clear whether this is justified by the prevailing inflationary environment.

It would seem difficult to conclude that US stocks represent especially attractive value today, but they could be either reasonably valued or still over-valued.

What basis, therefore, is there for the prevailing sense of optimism about reasonably imminent recovery?

One might ask, “Surely, after the last three years, things must get better soon?”

This may be a fervent wish, but it is not a systematic method for forming judgements about portfolio construction. Besides, there are many historical precedents for US markets staying down for periods far in excess of three years.

The financial planning industry cannot rewind the past, we can only learn lessons from it.

There needs to be a fundamental re-thinking of portfolio construction. This needs to acknowledge that, over many periods of time, stock markets will outperform. It also needs to recognise that there are long-term periods where this has not occurred and, naturally, many of these periods began when markets were over-valued.

There is a growing trend for planners to outsource asset allocation decisions and this is a sensible step for many.

However, the parties offering this service need to demonstrate that they are following sound, research-based procedures. If they are simply allocating some proportion to growth assets and not adjusting this appropriately even when markets reach extremes, how will we avoid a repeat of the industry’s experience over the last three years?

The investment experience of many super funds with asset consultants demonstrates that, at times, purported expertise is sometimes overstated.