In defense of a prudent investment strategy

In a recent article, Albert Edwards, strategist at Société Générale, reiterated his view that the Standard & Poor’s 500 would establish a floor at 450. 450, not 1450! I too have written in the past about the possibility of this index revisiting its March 2009 level (670) in the coming years. These levels seem completely absurd given that the S&P 500 is now at 1625. But can they really be ruled out completely?

The following graph shows the price/earnings ratio of the US market according to Professor Robert Shiller’s version. In this version, the earnings used for the ratio’s denominator are the average earnings over the last 10 years for companies in the index, rather than the earnings of the last 12 months or those estimated by analysts for the next 12 months. The advantage of the Shiller version is that it normalises the earnings used and thus avoids being based on any one particularly good or bad year. This is important today since companies’ profit margins (and therefore their earnings) are at historically high levels. The graph shows that at its historic lows, this ratio stood at around 6. It is currently 23. A return to 6 would see the US market at the level predicted by Albert Edwards.

Shiller’s price/earnings ratio for the US market:

Source: Morgan Stanley

It is true that it would require extraordinary conditions for the value of the US market to fall to such a low valuation level: war, economic depression or rampant inflation. However, with the monetary policies currently being conducted by the central banks, there is no certainty that some of these conditions won’t return in the next few years. But even excluding such extreme scenarios and the particularly low valuations that would come with them, it is clear that:

- apart from 1929, 2000 and 2007, the US market has never traded at as high a valuation as it does today. In those three preceding episodes, the market subsequently plunged by at least 40%;

- the long-term average for this ratio is 16. To return to this average, the S&P 500 would have to fall to 1100, a 30% decline ;

- the market has historically oscillated between phases when for several years the ratio was above this long-term average, and long phases when it was below it. Apart from a brief period in 2009, the market has been expensive since the middle of the 1990s. Stock market history seems to suggest that such a period of overvaluation will be followed by a period of undervaluation. Supposing that without falling to as low as 6, the Shiller ratio were to drop back to around 10 to 12 (where it has often been in the past), the S&P 500 would fall to between 700 and 850.

One might argue that in the above, I have assumed ‘all other things being equal’. It is true that a decline in the price/earnings ratio could also happen due to an increase in the denominator (earnings) rather than due to a decrease in the numerator (share prices). However, it should be remembered that Shiller’s version of this ratio uses the average earnings over the last 10 years. Since this is an average, it will not by definition see spectacular variations from one year to the next. Yet for the ratio to return to its long-term average of 16 without a fall in share prices, average earnings for the last ten years would have to a rise by around 45%. It is also important to note that we are talking here about the market as a whole. But just as it is reasonable to assume that for a company like Coca-Cola, earnings in 2013 will be substantially higher than those in 2003, and that in the calculation of average earnings over 10 years, a low figure (earnings in 2003) will be replaced by a considerably higher figure (earnings in 2013), this reasoning is less convincing for companies across the board. And even in the case of Coca-Cola, this exercise would only raise average earnings by 8%.

The aim of the above is not to say that the US market will fall by around 50%. It is in fact to point out that such a fall is not impossible and, above all, to show that people who are today arguing in favour of a prudent strategy have history on their side and that really, it is up to those who are expecting prices to keep on rising to show why, this time round, things should be any different and why the principle that the price determines the return is no longer applicable. Especially at a time when the economic indicators are deteriorating again and, unlike in the period from 2009 to 2011, earnings growth is no longer a reality .

For many observers, the response seems to lie in the low level of interest rates. given that in manipulating interest rates to keep them artificially low, the monetary authorities are encouraging investors to seek alternatives to fixed-income investments and in particular, to buy equities. Investment decisions are therefore not being taken based on fundamentals and this distorts them. And while, in the financial sphere, quantitative easing seems to be having the effect of driving asset prices higher, there is nothing to show that they are having any effect in the real sphere by stimulating economic activity in a sustainable way. Generally speaking, investors have dismissed the possibility of a significant fall in share prices as long as the central banks continue their current policy.

A defensive strategy is frustrating in this type of environment where share prices are continuing to rise despite the deterioration in fundamentals and valuation multiples at levels which in the past did not suggest good prospects for returns over the following years. Over the following years. not the following weeks: the fact that equities are expensive won’t necessarily stop them from continuing to rise for a while yet. But it is really important to remind ourselves that at current levels, the main risk is not missing out on a further rise but forgetting the lessons of stock market history.

Guy Wagner Managing Director