The Writing Is On The Wall... And We Should All Read It
The "Shiller P/E" is much in the news of late, and, as ConvergEx's Nick Colas suggests, with good reason. It shows that U.S. equity valuations are pushing towards crash-worthy levels. This measure of long term earnings power to current price is currently at 25.3x, or close to 2 standard deviations away from its long run median of 15.9x. As Colas concludes, the writing is on the wall and we must all read it. Future returns are likely going to be lower. Competition for investor capital will get even tougher. That’s what the Shiller P/E says, and it is worth listening.
Via ConvergEx's Nick Colas,
With all the investor attention on this measure, you don’t hear much about how it should inform corporate capital allocation and investor relations. Since stock prices are essentially a conversation between the owners and managers of capital, the Shiller P/E should have a place in the boardroom as well.
For example, should companies engaged in buybacks be more careful at these levels, and how do they explain that caution? And what about managing investor expectations for future returns on the business, and therefore its underlying equity? After all, the higher the Shiller P/E, the more likely that future returns will run below historical averages. In short, this is not just a useful tool for investors – it should also inform corporate capital planning and communication.
On the table in my den I have a plaque with Mercedes-Benz and Chrysler hood ornaments glued to the top. It is a deal toy – those commemorations that investment banks give out to the people who work on a specific transaction. You see them littering the officers of corporate treasurers and chief financial officers, bankers, and private equity professionals. The more toys, in theory, the more experience the person has. And the more elaborate the toy, the more creative the 28 year old investment banking associate who really did all the work getting that deal across the finish line.
You could tell that the merger of Daimler and Chrysler was going to fail by just looking at those hood ornaments on the deal toy. Daimler-Benz mounts its famous three pointed star (for land, sea and air transport) on a spring, so that in the case of an inadvertent knock it pops back up unharmed. The corporate name and laurel wreath on the base is done in a lovely blue lacquer worthy of a piece of jewelry. In contrast, the Chrysler hood ornament feels flimsier, has no spring mount and no lettering. One sharp blow and you just know the thing would snap two. And there’s really nothing wrong with either engineering ethos – they are just different approaches for different markets. But culturally, they are like oil and water.
Of course, it didn’t help matter that the merger occurred in 1998, right at the peak of the North American auto profit cycle. Chrysler got over $40 billion for the company in Daimler stock. Nine years and one forced CEO (the architect of the deal) departure later, Daimler sold Chrysler to private equity firm Cerberus for $6 billion. And two years after that the company filed bankruptcy. You could, in essence, time the tops of every market for the last two decades on when Chrysler changed hands.
The U.S. stock market has its own “Chrysler Indicator” in the form of the Shiller Price/Earnings ratio. First developed by Nobel Prize winner Robert Shiller for his book “Irrational Exuberance” in 2000, it measures the current price of the S&P 500 as a multiple of 10 year average corporate earnings. It is essentially what old-school analysts would call an earnings power ratio, since it incorporates good and bad years into one across-the-cycle measurement. A few points here:
The current reading on the Shiller P/E is 25.4x. Looking at a time series back to 1880 (available here: http://www.multpl.com/shiller-pe/) this is quite expensive. The mean observation is 16.5x, and the median is 15.9x. The cheapest-ever U.S. stock market was in December 1920 at 4.8x, and the most expensive was in December 1999 at 44.2x.
For you bell-curve fans out there, the standard deviation of the 1,600 monthly observations back to 1880 for the Shiller P/E is 6.6. That puts 95% of the distribution between 3.3x and 29.7x. In other words, at the current reading of 25.4x we are knocking on that upper bound. Put another way, levels above 25 only occurred once before the mid 1990s, and that was going into Black Tuesday 1929. And the Black Monday 1987 crash happened with a Shiller P/E south of 20.
Now, a few words of “Maybe this time is actually different” caution. First, stock valuations and interest rates are lashed together like unwilling participants in a three legged race at a corporate retreat. Long term rates are still near historic lows, so stock valuations do have the oxygen to survive at these elevated levels. Second, accounting standards change like the wind, so comparing reported earnings in 1914 to 2014 is always going to be difficult. Thirdly, the S&P 500 posted its one and only quarterly loss in 2009, so perhaps that 10 year earnings record is too pessimistic. Lastly – and giving the bearish case a little room to run here – Federal Reserve policy in the form of bond-buying does prime the market’s liquidity pump in a unique and unpredictable way. This has been positive for stocks, but the story isn’t over yet.
Even with those caveats, the Shiller P/E is a clear voice in the wilderness calling for investor caution. History may not repeat itself, as the old saw goes, but it often rhymes.
Turning back to the Chrysler example for a moment, what if corporate managers paid as much attention to the Shiller P/E as investors should and increasing actually do? Are there points in the cycle where the smart corporate money just waits out the froth? Some thoughts on this question:
At the heart of the question is the concept of expected future returns. The real reason that investors value the Shiller P/E is because it is a reliable forecasting tool for what the market will do over the next few years. At current levels, for example, average real 3 year future returns are only 5% or so (see the sources at the end of this note for the graph).
The analog in the boardroom (rather that the trading room) is the Equity Risk Premium (ERP). This calculation has its own guru, NYU Finance Professor Aswath Damodaran. His calculations show something similar to the Shiller P/E: companies should assume that investors require a higher rate of return during periods of crisis than during times of exuberant confidence. Interestingly, he comes to observation through a very different set of exercises ranging from stock versus bond return data to surveys of investors and corporate managers to expected future cash flows and assumed discount rates.
For the most recent month, Damodaran pegs the U.S. Equity Risk Premium at 5.1% based on trailing earnings, which puts the expected rate of return on the U.S. stock market at 7.7% with the current 10 year Treasury yield of 2.61%. That’s based on your friendly neighborhood Capital Asset Pricing model with a beta of one, a.k.a. the market beta.
There’s a large gap between what the Shiller P/E tells us to expect – sub 5% returns – and the 8% (rounded up) on the corporate side. Essentially, the expected future return of stocks used in the boardroom to plan capital projects is about double what an investor using the Shiller P/E has any logical right to expect.
If that sounds like a lot of inside baseball/jargony hogwash, rest assured that there are real world applications that make this conversation highly relevant today. For example:
Mergers and Acquisition Analysis. Simply put, it is a good time to be a seller if you are a public company listed on a U.S. exchange. You won’t find that observation in your internally-created discounted cash flow analysis, because it likely uses a standard cost of capital number such as the ones Damodaran calculates. More realist expected returns – such as those that correlate to Shiller P/E measures – mean that any significant future gain will be much harder to achieve.
The corollary is that buyers of public companies should use their own stock as a major source of capital in any transaction. Yes, M&A has a spotty record of creating shareholder value, but don’t compound that challenge with financial leverage at this point in the cycle. Use stock. Notably, the tech sector has clearly gotten this memo.
Stock buybacks. This one is tricky, because there is so much misinformation about what stock buybacks are supposed to accomplish. The clear-eyed view is simple: companies buy back their stock when they have excess cash flow that cannot be effectively reinvested in the business. Also, this extra capital is generally cyclical in nature, so managers don’t want to create or up a dividend just to cut it back with the economy weakens.
This puts many companies in a tough spot, however, because cyclical cash flows tend to occur (spoiler alert) when things are good and the stock is strong. Buying the stock back at these points in the cycle may lead to some embarrassing moments on future quarterly financial calls if it declines precipitously from an economic slowdown or (worse yet) shock to the system.
The Shiller P/E is flashing a modestly cautious yellow hue to buyback programs at the moment. At the same time, activist investors everywhere are also on the lookout for cash-rich companies to engage, and buybacks are often the first page in their shareholder value playbook. In the end, companies are a bit between a rock and a hard place at the moment. Strong free cash flow plus activist investors equals the need to keep buying back stock even at lofty levels. Let’s just be careful out there.
Investor relations. This most underappreciated corporate function is where the rubber hits the road on the topic of Shiller P/Es versus standard cost of capital calculations. In a nutshell, it has never been more important to underpromise and overdeliver results. Not since 2007, anyway. Remember that future returns are more likely to be less-than-5% rather than the 8% you see in internal corporate presentations. The rising tide of the last five years is unlikely to continue, so every public company will be in fiercer competition for investor capital as future returns drop.
In summary, the times change and everything from capital allocation to investor relations have to change with them. That is potentially a tough lesson for many companies to embrace, since a consistent approach to capital planning and communication is comforting to many managers. Still, the writing is on the wall and we must all read it. Future returns are likely going to be lower. Competition for investor capital will get even tougher. That’s what the Shiller P/E says, and it is worth listening.
You don’t want to go the way of rich Corinthian leather. Do you?
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