With market indices sliding, the bears are emerging from their hibernation to shout ‘I told you so’. Markets, especially equity markets, inevitably journey through periods of negative returns, so eventually, the bears must be correct.
The bear case however has been building, even as many stocks have fallen significantly further than the few percent displayed by the major market averages. Nevertheless, the bears do suggest there is much further to fall.
So what are the arguments proffered by those whose pessimism is increasing in volume? More importantly, what is the opportunity?
The first argument is one we have tackled many times in the past; the Shiller CAPE ratio is extended (indeed it hovered at historic highs for some time) and the S&P500 must therefore retreat.
Back in October 2020, after examining and discounting any correlation between the CAPE ratio and interest rates, we concluded we might simply be, “…in the middle of a good old-fashioned bubble in technology and growth stocks.”
We have also previously argued the quality of the majority of FAANGM stocks – their market cap explaining fully a quarter of the S&P500 – was unlike anything ever seen before. Indeed, we have demonstrated how these businesses grow their return on equity even as their equity expands significantly. That is first prize when it comes to business economics.
These businesses (Facebook, Amazon, Apple, Netflix, Google and Microsoft) are scarce assets, they have long runways for growth, and they are monopolists with pricing power.
They are the very businesses long-term value investors like Warren Buffett salivate over. But poor investments can be made in even the highest quality businesses when the price paid is too high. It is a simple reality of investing that the higher the price you pay, the lower your return.
Another reality is extreme multiples for scarce assets is a common occurrence during periods of low interest rates, and particularly when rates are lower than trend economic growth rates.
But extreme multiples are not usually sustained in history. Meanwhile growth for these companies has recently slowed. High prices and declining growth are typically unhappy together.
Low interest rates (whether they are artificial or not) have a disproportional effect on the present values of earnings further out. The present value of $100 earned in a year’s time rises by 4.76% when interest rates halve from 10% to 5%. But the present value of $100 earned in 15 years rises by 100% when interest rates halve from 10% to 5%.
Therefore, the biggest jump in intrinsic values occurs for those companies with the bulk of their value in the terminal part of the calculation. Start-ups and emerging companies with little profit today, but expected to earn much more out over the horizon, see their theoretical value rise the most when interest rates are cut.
The reverse is true when interest rates rise.
What goes up must come down…(and then go up again).
Even low interest rates can’t immunize a company’s shares from shocks and falls. Ultimately, the growth in expected earnings must be delivered and for the price to continue rising from already-stretched levels, the P/E must expand even further. That means the company must exceed already optimistic expectations. And life simply doesn’t work out that way. There are always potholes on the road.
So, even the very best quality companies inevitably see their shares prices suffer from subsequent pull backs. Of course, that’s when investors should be ready to take advantage of the manic-depressive nature of markets to lock in better future returns, along with the security of owning very high-quality businesses.
And while companies are prone to share price declines, even in a low interest rate environment, they are almost obligated to fall in an atmosphere of rising rates. This is because the whole process of rising intrinsic valuations is reversed.
PE compression when bond yields surge…
One theory goes something like this: equity investors demand a return – commensurate for the risk of investing in equities – above the risk-free rate (RFR), and through the actions required to satisfy the need for an appropriate return, markets will find an equilibrium. The market’s equilibrium PE multiple can then be explained by a formula that takes the risk-free rate and equity market risk premium into account with an adjustment for growth.
A quick example is useful. Rates on long term government bonds are widely employed as proxies for the risk-free rate. Late last year the Australian government sold 31-year government bonds at around 1.90 per cent (keep that number in mind). The equity market risk premium at the time was estimated to be around three per cent. Add the two together and we arrived at a theoretical equilibrium earnings yields of around five per cent. The PE ratio is the inverse of the earnings yield, so if we divide one by five per cent, we derive the equilibrium PE ratio of about 20 times earnings. The PE for the ASX200 at the time was about 19.85 times, suggesting it was about fair value.
The above however doesn’t consider growth. To do that we need to subtract the growth rate from the earnings yield in the denominator. In the above example, if growth is two per cent then we subtract two per cent from the five per cent to arrive at three per cent. Divide one by three per cent and we arrive at a fair value PE of 30 times. Perhaps unsurprisingly, when we removed financials from the ASX200, its PE was about 30 times.
When interest rates rise of course, the equilibrium PE is lower and a market PE of 30 looks decidedly unsustainable.
Today, the Australian 30-year bond yield is 3.587% (it’s up over 100 basis points in just six months!). If the equity market risk premium is still three per cent (and that’s arguable) the theoretical equilibrium earnings yield is almost seven per cent. The Equilibrium PE is therefore 14.3 times. That represents a 28 per cent decline in the equilibrium PE ratio of 20 times we estimated in October last year. And if growth is still two per cent (more on this in a moment) the equilibrium PE is about 20 times which is down fully a third from last October’s growth-adjusted equilibrium PE.
Today, perhaps unsurprisingly, the ASX 200 PE is 14.9 times and the ASX200 ex resources is 19.2 times. Having fallen from an unsustainable PE of 30 times, it seems equity markets are indeed very good at contemporaneously adjusting for the changes in bond rates and risk.
Inflation and interest rate expectations rising, and growth expectations declining
Last year, prices for equities, property, farms, wine, stamps, coins, art and even low digit number plates were supported by the assumption interest rates would remain low for a very long time. Indeed, I believe it may still be the case that ‘average’ bond rates will indeed be low over the next decade, but that does not mean a bout of steeply rising rates can’t hurt some, and be an opportunity for others, in the meantime!
Many believed US 10-year treasury yields would remain around 1-1.5% for the indefinite future. No wonder investors were ‘off to the races’ so to speak.
But to heap burning coals on the head of now rising bond rates, expectations for short-term rate hikes have increased materially since last year as well. When bond rates were at or near their lows, the number of short-term rate hikes expected over 2022 was no more than three. Today the market is expecting a major formal adjustment in short-term rates of up to 10 hikes.
Amid such a violent shift in expectations, and remembering the relationship between rates and equity valuations, it should come as little surprise PEs have compressed, and consequently, share prices have slumped.
The reason for the significant upheaval in rate expectations is the shift in short-term inflation expectations. Driven by supply bottlenecks, wages growth and the trillions of dollars pumped into the economy and financial system during the pandemic, inflation expectations are significantly higher than at the same time last year.
According to Roy Morgan, back in January this year, expected inflation was 4.9 per cent annually over the next two years, up 0.1 per cent points from December 2021. Importantly, this level equalled the seven-year high reached in November 2021 – the highest since November 2014. Australian inflation expectations at the end of January, were 0.2 per cent points above the long-term average of 4.7 per cent and a large 1.3 per cent points higher than a year ago in January 2021 (3.6 per cent).
And then it got a whole lot worse.
In March 2022 Australians expected inflation of 5.8 per cent annually over the next two years, up 0.9 per cent points from January 2022. The level of inflation expectations in March is the highest for nearly a decade since September 2012 (5.8 per cent).
According to Roy Morgan, the increase in March was also the largest monthly jump in the index since inflation expectations increased by a record 0.8 per cent points in January 2011 to a record high of 6.6 per cent during the middle of the then ‘Mining Boom’. Inflation expectations are now 1.1 per cent points above the long-term average of 4.7 per cent and a large 2 per cent points higher than a year ago in March 2021 (3.8 per cent).
Reining it in. Recession anyone?
Central banks globally are now fighting to prevent very high short-term inflation expectations from becoming the much more damaging long-term kind.
The new dual roles of some central banks – to keep a lid on inflation and to keep employment close to full – makes monetary policy nothing less difficult than a tightrope walk. A soft landing is what they would like but having one’s cake (raising interest rates quickly and decisively) and eating it too (a soft economic landing) is not always possible.
Consequently, the spectre of a recession is rising. And while a recession is merely two quarters of negative growth – something that might pass rather quickly – the impact on businesses, employment and those servicing debt, in the interim, is much more relevant to investors.
Rising interest rates and a recession are bedfellows unliked by equity investors. Their presence alone raises the risk PE ratios compress even further. Markets could still fall a long way if PE ratios fall back to long term trends, and they could fall even further if investors overreact on the downside. And the combination of surging inflation, bursting supply chains, rising wages expectations, rising interest rates, the prospect of a recession and a nervous geopolitical climate, along with the threat of an expanding world war, offers investors every excuse to overreact.
We note, however, based on current bond rates, PE ratios for the major ASX indices are at about equilibrium.
A silver lining amid maximum fear
It is worth remembering that over the long-run markets rise because businesses able to add value grow, enter the market indices, and driving them upwards. The setbacks tend to be short-term affairs whose ends are frequently, but not always, marked by a period of ‘maximum fear’.
We haven’t reached the point of maximum fear yet, and we may not, but investors should be on high alert, ready to take advantage of the opportunity to invest, should fears triggered by economics or geopolitics cause PEs to swing too far downward.