- All told, we continue to see a lot of storytelling as to why investors should remain long of US equities here. Unfortunately, that storytelling is not completely supported by the data.
- In fact, our analysis suggests that the consensus long-term bull case for owning US equities up here (“stocks are cheap”, “investors are underweight equities”, “dividend yields are compelling”, etc.) actually leads investors right to one of the most supportive theses for meaningful equity market weakness over the intermediate-to-long term.
- That thesis is: stocks are not cheap (on a cyclically adjusted basis), fund flows are likely to continue favoring fixed income in lieu of equities and one of the core reasons why dividend yields are so compelling is because of the low interest rate environment perpetuated by ZIRP, which, perversely, perpetuates a shift of even more flows into fixed income funds to supplement slowly compounding returns. We show data to support each of these claims in the note below.
On AUG 6, we published a note titled, “DEBUNKING THE STRUCTURAL BULL CASE” in which we attempted to stress test some of the common long-term supportive theses for owning US stocks – including investor asset allocation, demographics and corporate earnings. The conclusion of the note was rather simple:
“We see downside risk in the US equity market over the intermediate term as the structural bull thesis is riddled with shortcomings.”
That view, which was published at ~1,400 on the SPX, remains our base-case scenario – a scenario that continues to be well-supported by our cyclical concerns (per our 4Q12 Macro Themes; email us for replay materials):
- Bubble #3
- Keynesian Cliff
Mutli-factor, multi-duration scenario analysis remains a core tenet of our Global Macro research process. In expanding upon our longer-term work, we use the prose and charts below to incrementally debunk the structural bull case for owning US stocks up here.
Before we go any further, it’s important to note that we are not perma-bears; nor do we have a bone to pick with the US equity market. Rather, we continue to register high levels of asymmetric PRICE risk across domestic stocks – particularly relative to the fundamental DATA – and view exercising caution as the prudent thing to do here. Any sell-side strategist can come up with a 1,001 reasons why you should buy stocks hand-over-fist here; we suspect clients are looking for a more holistic view.
STOCKS ARE NOT CHEAP
Nor are they particularly expensive, either. Using data from Yale Professor and author of Irrational Exuberance, Rober Shiller, we chart the US equity market’s cyclically adjusted price-to-earnings multiple on both a nominal and real basis going back to JAN 1881. The latest readings (OCT ’12) are 24.1x and 21.4x, respectively. Moreover, the latest readings are each -0.5 standard deviations relative to their respective 10yr averages – i.e. not at all expensive by any means, but also not particularly cheap either. We would consider a “cheap” market multiple to be in the area code of -2 to -3 standard deviations oversold.
WHY ARE US EQUITY MARKET MULTIPLES IN SECULAR DECLINE?
Looking at the first chart, one would be keen to notice that the US equity market’s multiple on a cyclically adjusted basis has been in secular decline (i.e. making long-term lower-highs) since its late 1999/early 2000 top. There are obviously a number of reasons for the development and continuation of this long-term trend; we agree that sentiment, money supply, the velocity of money, savings rates, asset allocation decisions, earnings growth and other catalysts have all played a factor.
One catalyst that is perhaps less discussed on a broad scale, but remains blatantly obvious to us is demographics. As the following chart shows, the percentage of the US population that is generally inclined to reallocate funds from the equity market into fixed income products has grown rapidly since that peak. The data certainly supports what the storytelling implies: as baby boomers continue to age en masse, they will increasingly be inclined to shift their portfolios from capital appreciation mode to capital preservation/cash flow mode, at the margins.
It’s important to note that this phenomenon will remain a structural headwind to the US equity market’s multiple and fund inflows for quite some time. We’re already seeing undeniable evidence of this via mutual fund flows, which have been overwhelmingly in favor of fixed income funds at the expense of equity funds since the start of 2009 – despite the US equity market being up over 100% “off the lows”!
QUANTIFYING THE CASE FOR STRUCTURAL EQUITY MARKET OUTFLOWS
Perhaps the aforementioned headwinds are precisely why Bernanke remains staunchly committed to ZIRP (now pledged through mid-2015). Acting as an artificial levee, Bernanke may be attempting to hold back the flood of capital that would otherwise be inclined to ditch the equity market(s) for the perceived safety and income of bond funds.
On the bright side of the ledger, the Federal Reserve’s easy monetary policies have been great for corporate balance sheet repair and earnings growth – both of which have been very supportive for dividend expansion. Equity investors continue to tout dividend growth/yields as a key reason to remain long of US equities; it’s worth noting that we agree that both catalysts are indeed supportive. Also supportive has been the boost to investor sentiment and the prices of “risk assets” into and through previous iterations of QE/OpTwist.
All that being said, however, we are inclined to argue that the hole being burned into the consumer’s income statement due to a lack of yield on interest-bearing assets might actually compel baby boomers to shift even more of their savings out of equities and into fixed income funds if they are seeking to hit some predetermined target for savings at retirement (i.e. they need to front incremental capital to fixed income funds because those interest-bearing investments now compound at slower rates; see: Japan). This view is supported by the fact that dividend income growth has demonstrably failed to keep pace with the decline in interest income in recent years, rendering total personal income receipts on assets off -26.7% from their 1Q08 peak in real terms.
All told, we continue to see a lot of storytelling as to why investors should remain long of US equities here. Unfortunately, that storytelling is not completely supported by the data. In fact, our analysis suggests that the consensus long-term bull case for owning US equities up here (“stocks are cheap”, “investors are underweight equities”, “dividend yields are compelling”, etc.) actually leads investors right to one of the most supportive theses for meaningful equity market weakness over the intermediate-to-long term.