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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
ED EASTERLING – STOCK MARKET VALUATIONS
ARE STILL EXTREMELY HIGH
October 31, 2018
“Crestmont’s work starts with principles and delivers the information to help investors understand the environment. The biggest criticism about Unexpected Returns, people got toward the end and said, ‘But wait a minute, you didn’t tell us what to do.’ There are lots of folks out there who can tell you a variety of ways to do it. I think the first step is understanding what you want to do, and understanding the environment that we are confronting, and the principles that drive the market.”
– Ed Easterling
Kevin:Our guest today, Ed Easterling, is a pattern recognizer. He reminded me of one of my clients who works for Los Alamos National Laboratories who has this unusual gift of taking a lot of different pieces of information and seeing a picture. It is a gift that we don’t all have.
David:What would you do if you had a career in private equity, and then had a career in the financial market business, and then wrote a number of books, whether it wasProbable Outcomes, the first that he wrote, the second, Unexpected Returns, and he co-authored a number of them with John Mauldin – what would you do for an encore? For him, the encore is becoming a timber and cattle man.
Kevin:Isn’t that something? He is going to go punch cows now this afternoon after doing the interview.
David:Doesn’t that just make sense?
Kevin:One of the things that caught my attention when I was reading Ed’s book was that he mentioned celestial navigation. Actually, celestial navigation is this amazing thing where you can take readings of stars and, really, within about a 250-foot placement you can find out where you are anywhere in the world. What Ed is doing with his books is he is taking something that seems very random, very large, like stock market news, cyclical and secular, and he is saying, “Wait a second. There are about three things you need to look at to see whether you are over-paying or under-paying for a stock.”
David:What he is doing, really, is teaching you how to think about the markets, and he takes a very educational approach. If you have spent any time at CrestmontResearch.com, he has a number of published articles, as well as videos, which are available there online bringing out his background, not only in the capital markets, but also as an academic. He served as an adjunct professor and focused on investments and hedge funds for MBA students at SMU in Dallas, served on the board there for a number of years, again, prior to becoming Ed the cowboy. He has quite the educational background, specifically, in the area of finance and investing.
Kevin:What you are talking about with these sites and with this educational material, it is all open access. In other words, there is no charge for this. So for the person who does have an economic and financial curiosity, they can go to the site, Crestmont, and get it for free.
David:We have the link there taking you, specifically, to what I mentioned last week, the stock market matrix. He has an updated version of it on his website. Of course, it is on page 28 and 29, as I mentioned last week, of his book, Unexpected Returns, but click that link and dive into the rabbit hole, if you will, exploring some of the interrelationships within the markets with different economic variables all mapped out there for you.
Kevin:And I can highly recommend that. It is a little bit like sitting down and looking at a world map, which has been a fascination of mine since I was a kid. You found his book, originally, in a used book store.
David:A number of years ago I came across a book in a used book store, Unexpected Returns: Understanding Secular Stock Market Cycles, by Ed Easterling. As I opened the first page I found that it was a signed copy, and I thought to myself, this is very intriguing because secular stock market cycles are a passion, they are an interest to me, from a historical perspective, and of course, for what they can help you understand about future trends, as well. So I bought the book and found surprise after surprise after surprise – things that I did not know, points that I had not connected, and found that my education as I went through Unexpected Returnswas immense. So I have a debt of gratitude to Ed Easterling.
* * *
It is great to have you on the program today. I want to dive right in on the idea of secular stock market cycles. There have been eight secular periods which have occurred over the last century. We have had four bull markets. We have had four bear markets, varying between four years and 24 years in length. Why don’t we frame the discussion today by looking at history as a guide? Where should we begin?
Ed:I think the first is to recognize that the secular cycles you describe, to understanding the underlying cause and driver of those cycles, and really, defining them, as well. The secular stock market cycle derives from the term secular, which is based on a Latin term, secula, which just means a long-term period or an era. So when we sit here and talk about secular stock market cycles, all we are talking about is extended, or long-term, periods.
But as you mention, some of them are shorter and some are extremely longer, sometimes over 20 years. The key is to recognize that the driver of those cycles is not just time or coincidence, but rather an underlying fundamental factor, and that is something I’m sure we will dig into in our discussion today.
Dave:Over and over you say starting valuation determines long-term returns. I have seen this in papers that you have written, I have seen this in both your books,Unexpected Returns, which I mentioned, and also a more recent book, Probable Outcomes,and I think, required reading. Certainly should be on the shelf, but I would suggest the highlighter and red pen to dive in deeply. Over and over you say this, “Starting valuation determines long-term returns.” Talk to us about valuations at present, and what that might imply about future returns.
Ed:Currently, stock market valuations are extremely high. They are some of the highest they have been in the past 100 years, not quite exceeding the period of the late 1990s, but exceeding every other period. High valuation impacts returns in several ways. First, an investor in the stock market, other than what they do and their selection of stocks, etc., they get return from three components.
There are only three components to stock market returns. There is earnings growth, their dividend yields, and then there is the change in valuation level, the PE ratio. The change in valuation and earnings growth determine what you get in capital gains, and the extra return that you get above capital gains comes in the form of dividend yield.
The simplest example of this is that when valuations are high, or when valuations are low, that doesn’t change dividend policy. Companies still pay the same dollar’s worth of dividends. But if that dollar of dividend comes to you when you are paying 20 times earnings, or let’s say $20 a share, the yield from that is half of what it is if you only pay $10, or ten times earnings per share for the stock. So PE ratio, or the price versus the earnings, or the level of valuation that you pay for the stock, changes significantly the level of yield that you get, and a significant component of your total return from investing in stocks.
If you invest when valuations are low, valuation has two ways it can go. It can stay steady or it can go up, and that rising valuation adds to return. But if you start out paying a high price for stocks, again you have two ways it can go. It can stay steady at high, or it can go down. And if it goes down, that takes away from your return, it lowers your capital gains. So valuation matters so much because valuation drives the two components of return from investing in stock markets.
Dave:I had a client meeting last week and we were discussing dividend yield. This was a portfolio that was coming in to us and the average dividend yield was about 2.4%. Relative to what cash rates have been of late, this gal was pretty enthusiastic about 2.4%. I let her know that Charles Dow had this perspective, that unless you were buying stocks in and around a dividend yield of 5-6% your rate of return should be expected over the next 10-15 years to be subpar, so actually, dividend yield indicating that you are at the wrong end of the spectrum.
PE, you mentioned, as an important component there. Above average returns occur when PE ratios start low and rise, and below average returns occur when PE ratios start high and decline. On that continuum, you said we are extremely high. Can you talk to us about the Shiller PE, the cyclically adjusted price earnings multiple and the Crestmont PE. Your Crestmont PE is a little bit different, but I think very complementary. And actually, there is this confluence between CAPE and the Crestmont PE, which in my mind are mutually validating. Talk to us about where we are in the continuum and what CAPE and Crestmont tell us.
Ed:Sure. The reason we use a PE that is different than just a reported PE is that earnings is that earnings go through a cycle. We go through periods of high profit margin levels and then come back to low profit margins levels. It is part of a cycle that encourages new business formation and then flushes out inefficient businesses. That fluctuation can create noise. There are several ways to adjust for that noise. The way that Bob Shiller yield adjusts is that he looks at an average of the inflated-adjusted earnings over the past ten years. The CAPE PE, or PE-10, is a recognized way to normalize that fluctuation and come up with a number that is more consistent. So you avoid trying to calculate a PE based upon the earnings drop of 2008, or earnings surges that have occurred every several years.
The Crestmont approach looks at the fundamental relationship between the economic growth, or GDP, and the earnings-per-share. So GDP, or Gross Domestic Product, is essentially the aggregate sales of all companies, and earnings-per-share are the profits of publically traded companies. So the earnings are the bottom line of an income statement. The sales are the top line. So of course, the two over time would have a fairly consistent relationship as we normalize that cycle for earnings. You mentioned a second ago that our two methods are different. One is an averaging method, one is a fundamental relationship method, but both of them going back over 100 years show a fairly consistent, with a high correlation, relationship. Now, they are based on the same fundamental concept, but they are driven, if they are developed, in very different ways. But I think the fact they show such a high correlation shows that the concept of formalizing earnings is valid and the value of doing it is to help avoid the distortions of those extreme periods of either high profits or low profits that can distort price-earnings ratios that would send a false signal about future profitability of investing in the stock market.
David, one thing you said a moment about high valuations. When we start with high valuations and we go down in valuation it drives below-average returns. Keep in mind in today’s environment with high valuations, even if valuations stay high, we’re destined for below-average returns. Because if valuation stays high, we are going to have a dividend yield that is less than half of the historical average. And if valuation stays high we can’t get the rise in valuation that is a part of that historical average 10% return.
If valuation is high today because the inflation rate is low that means that nominal economic growth and earnings growth will be lower than it was historically. So every one of our components is destined to be below the historical average, and therefore the aggregate is going to be well below the historical average. And if valuation goes down, it only makes it worse.
Dave:If we have time, later in our conversation I would love to talk about a more recent paper that you put out, “The Big Shift,” because there is that idea of possibly moving into a lower range for PEs, and maybe we can circle back around to that.
Your second book, Probable Outcomes, begins this way. In the introduction you say, “A decade has passed and yet the secular bear is not close to being over.” This was in 2010 when you wrote the book. The secular bear is not over. What happened from 2010 to 2019? We’re nearly there – 2019, that is. What happened in that timeframe that was surprising? And maybe you could comment on bull and bear markets not being time-dependent.
Ed:Two things come to mind, and first let me just say as we go through this and I just made the comment about how we are set for below-average returns, I don’t want the message for the listeners to be that I’m bearish, or that our discussion is bearish. As a matter of fact, I come at this, not as a stock market weather forecaster, but as a stock market climatologist. So the value of this conversation, and the value of understanding this information is to help people understand the environment within which they are operating.
It is almost like we are sitting in front of the Future Farmers of America and someone walks up and says, “We’re getting ready to head into winter. It’s going to be cold and the sun is not going to be out as much.” You could get dreary and down about that or you could sit up and say, “Hey, wait a minute. I see opportunity here. What are the crops I need to plant? How do I need to approach this so that I am the most productive through the winter?” And that’s when you pull out the winter wheat and squash and a whole bunch of other crops that do well in winter that don’t do well in summer. Although summer is a great bountiful period there are still many ways to be very profitable in winter.
Now, I think, to your question about Probable Outcomes– what happened? Probable Outcomeswas a book that was written for the reader to apply their own outlook for economic growth, and for the inflation rate, to determine their outcome, the probable outcome for the decade. There was a mama bear, a papa bear, a baby bear, but the bear that has happened, or the closest to happening, is the bear in hibernation.
We saw price-earnings ratios stay, not only high, but even go higher during this past decade. So we are definitely positioned for below-average returns. We are not positioned, and we can’t get to be positioned, for above-average returns until valuation goes down, which would be, essentially, completing the secular bear market.
So the key takeaway from this discussion is, we are in a secular bear because valuations are high. Because valuations are high we are destined for a period of below-average returns. It can stay modestly below average and just be a bear in hibernation, or it could be, as the past secular bears were, very low or negative returns for an extended period of time, and then we can be positioned for a secular bull.
So I think the biggest difference of Probable Outcomes, what has happened over the last decade is that inflation has stayed very low, and as a result we have had high valuations. And as a matter of fact, the last several years, I think for a variety of reasons, between euphoria and an apparent increase in profit margins and maybe perpetually sustainable profit margins, and just an extended period of low inflation that just drove a momentum that has pushed the market up to fairly lofty heights.
Dave:Then you have the opening lines of your first book, Unexpected Returns. You say that the returns in the market are primarily driven by inflation, and that may surprise some listeners. But talk to us about this idea of price stability, not just inflation as in the old inflation/deflation debate, but the idea of volatility off of a stable point, price stability, and the impact that has on pricing equities versus a move away from price stability in either direction.
Ed:I think the easiest to explain the relationship of inflation and PE is to first walk through the relationship of inflation with bonds. I think most investors understand that if you have low interest rates and low bond yields, you have high bond prices. Everybody who has watched their bond portfolio before, when interest rates go up because inflation starts going up you lose money on your bonds. At least temporarily, the bond price goes down. And likewise, you can buy a bond, you can watch inflation go down and interest rates go down, and that bond price goes up.
Well, bonds are financial assets, and so are stocks. Stocks just happen to be perpetual financial assets. So when the inflation rate goes up, which drives interest rates up, that drives the valuation of stocks down to increase their return over the future return to compensate for that inflation. So that inflation rate is, essentially, what the nerds would call the discount rate, for those future cash flows of earnings and dividends.
That is why the inflation rate, if you look back historically, we go through an inflation cycle. We go through periods of rising inflation rate, then periods of price stability, or down into deflation. When we go back and look at the relationship between valuation and inflation you find a very high correlation, going back over a century, that inflation is clearly, not only for the fundamental reasons I just described, not only why we would expect them to be that way academically, but we saw them act that way empirically.
Now we are in a period of relatively low, stable inflation. The inflation rate just seems to chip along somewhere around 1.5% to 2.5%, and even defied the expectations of the Fed. So maybe there is a hope or an expectation that inflation rate will stay that way for a long time and that is what has the valuation level up. But for listeners that think about the implications for a portfolio, it also means they should include in portfolios the types of investments that would diversify some of that inflation rate risk and make sure there is some protection just in case that goes up – that could have a pretty negative impact on the stock market side of the portfolio.
Dave:If I were to infuse an opinion there, that might be timber, that might be cattle, that might be gold and silver. It might be anything that is a real thing that tends to adjust upward when inflation becomes a concern. There is this issue we face today through modern portfolio theory which says if you diversify some of that risk between stocks and bonds you should be fine, and that is really what you need for a successful outcome in investing – sufficient diversification.
And yet, you are defining a component which is negative for bonds, and negative for stocks, in the event of an increase in inflation. Rising inflation rates hurt the bond price. Rising inflation rates – as you mention, discounted cash flow models and the discount rate there – all of a sudden it matters for stocks, too. You could see a correlation in the behavior of stocks and bonds and a down stroke for investors who thought they are sufficiently diversified under those circumstances, could you not?
Ed:Absolutely. I think there are several concepts that got conflated. They got over-simplified – the notion that stocks and bonds are not correlated. By the way, that is true over day-to-day periods. So on a given day, the stock market runs up and the money tends to go into stocks, comes out of bonds, bond prices go down. So you watch it daily or weekly and you might see some counter-correlation.
But that is just the daily fluctuations. Investors are typically investing over years, or maybe a decade. If you look over longer-term periods, for the fundamental reason we just discussed, stocks and bonds are highly correlated. And that is just not an academic exercise, let’s look back to the 1970s – great laboratory. In the 1970s inflation rose. Bonds got decimated, stocks got decimated. Then the 1980s came around after Paul Volcker put the kibosh on inflation and stocks rose and bonds rose, the greatest period of bond returns, the early 1980s, as interest rates fell significantly, as inflation fell significantly.
So those relationships – what the implication of this going forward is, and I think that is where modern portfolio theory and capitalizing the pricing model got a little misapplied, and that is 20 years ago, 30 years ago, when it became popular, there were stocks and bonds, and there weren’t a lot of other asset classes available for most investors. That has changed today. I think what Markowitz would say, and Sharp, and others, the application of these diversification tools should include all the asset classes, not just the two primary asset classes.
And as Markowitz led – when he wrote the paper, “Modern Portfolio Theory,” the very beginning, the first paragraph, talks about how his model is only as good as your assumptions. So the model is about, as you mentioned a moment ago, diversification to eliminate certain types of risk and get paid for market risk, but it isn’t a formula about how to get average returns. That only comes when the market is priced for average returns.
Dave:So there is that issue of average returns. You have Charles Dow, you have Robert Rhea, some of the folks that were writing about the markets, that created some of the indexes that we know and popularize them, they argued for the swings between over-valuation and under-valuation. You do, as well. And you have this issue of the “average return.”
Investor returns in the market are predicated on where you start. That is what we talked about earlier. And I still find many investors that believe in an average return in equities as if volatility is not a constant, as if volatility doesn’t matter. So the backdrop, the initial timing of investment – what is at risk when you ignore your starting point and just assume the averages?
Ed:Two things. I think, first, if you go in with the expectation that average happens if you wait long enough, then, first, you would tend to prepare, you would plan for retirement, for example, or live in retirement with the expectation that the portfolio is going to generate a 10% return, an average level of return from the stock market, when in reality, it is only positioned to deliver maybe half of that, 5-6% or less. So one, going in and planning for something that is unreasonable will set up for shortfall.
But second, and I think probably the more significant, is when evaluating alternatives – and you mentioned some of them earlier, some hard assets, or some different types of more actively managed approaches to investing – that when those alternatives present themselves with diversification, but let’s say a 5-6% return, a fairly consistent 5-6%, if you are weighing that against the average, people say, “Gosh, is it worth giving up 4 percentage points to take this investment into the stock market that is supposed to give me 10?”
In reality, if you are going into this with a period that is well above-average valuations, that has destined the market for below-average returns, maybe the steady 6 is competitive with the stock market outlook, and maybe even positioned for better returns if we were to see a decline in valuation. So I think waiting for average can lead an investor to make bad planning decisions and bad investment decisions.
And as a matter of fact, that is the title of an article I wrote a number of years ago – you can find it on the website – “Waiting for Average.” It basically walks through, in layman’s terms, a very short article that said it doesn’t matter how long you wait from here. Even though the long-term average is built around a 90-year average, you won’t, whether you wait 20 years, 50 years, or 100 years, from today, achieve a long-term average return because the components are not positioned to deliver that, fundamentally.
Dave:That really does come back to when you are engaging the markets. You have a great chart comparing PE ratios and dividend yields and how they match up, if you will. This goes back to your earlier comments on the component parts of returns. You have the earnings growth, the dividend yield and the PE ratio, or expansion or contraction of that multiple. The above-average return is going to be based on capturing a high enough dividend yield to skew things higher, and a below-average PE ratio to allow for multiple expansion.
And this chart was beautiful. Maybe I’m sounding like a nerd now, but it is beautiful because it appears that high PEs and low dividend yields are the birthplace of bear markets. And on the other hand you have low PEs and high dividend yields which are the birthplace of bull markets. Did I read the chart correctly?
Ed:Absolutely, Dave. And I think it is worth noting, the long-term average return that we all know and love, the 10% average – often we go down to Ibbotson’s Yearbook and see these long-term return series, and there you will see that the stock market return over almost the last 90 years, has been 10%. He actually breaks that into component parts – dividend yield of 4.5%, PE gain of just under 1%, and earnings growth of 5.5%. And that 4.5, plus 1, plus 5.5 is 10.
Again, this is where we almost need a warning label. That long-term series that generated the 10% that we all know and love started in 1926. In 1926, and according to Ibbotson, the PE ratio was 10.2. So the long-term average is what happens when you invested nine decades ago at a 10.2 PE – you get a 4.5% dividend yield as a result because your basis in a stock is so low, and you hold it over 90 years, when valuations then go up so you get an extra 1% per year from the over doubling of the PE ratio to add to your return.
So the long-term average is not some starting time insensitive period, or calculation, about what returns are randomly. It is the return that happens over a specific period that starts with low valuations. Ironically, had Ibbotson started his series when PEs were close to where they are today, we would know the long-term average to be close to 6% because we would only have a 2% dividend yield, we wouldn’t have the rise in PE, we would take away 3.5% of that 10%.
Dave:And if we go back to earnings growth, much of the earnings growth is predicated on GDP growth in general. So it really depends on where were are in terms of a cycle of maturity as an economy. Are we an immature economy with lots of growth ahead, or are we a very mature economy with less staggering growth, maybe consistent, but low, single digit growth. So there is a general assumption that if the economy is doing well, then the stock market should be, as well, just to pivot that a little bit. Can you explore with us how the economy and the market can behave independently for very long periods of time?
Ed:Part of the reason that happens is because the stock market is made up – the capital gains, the level of the market is the earnings level times the price-earnings ratio, the valuation of those earnings, whether we are valuing those earnings at a high number like 20, whether investors are paying 20 or 25 years’ worth of earnings up front to buy a stock, or whether they are only going to pay ten years’ worth of earnings up front. And it tends to fluctuate from a number that is just below 10 to numbers that are typically in the low to mid 20s, although right now we have moved up to about 30.
The key point was, the market is not just earnings growth, but also valuation level. We can have earnings, and earnings we talked about a second ago, emanate from sales, which are basically GDP, and that is why there is a close fundamental relationship between sales and earnings, and GDP and earnings. But over time that relationship mathematically gets distorted by the change in valuation level.
So the economy can grow strong but if the inflation rate is picking up and it is causing the valuation level to fall, the decline in PE will offset the gains in earnings and leave people with very few capital gains, if any. And the opposite can happen, as well. So the big driver here is the price earnings ratio. The big variable of return over a 5, 10, 20-year period, is the change in valuation. It is not the growth in the economy.
Dave:So we come back to inflation being a component which is a major impact to the driver, the price-earnings ratio. And you have in your financial physics model – this is a concept worth exploring on your website, crestmonresearch.com. But the financial physics model, maybe you can unpack that a little bit for us. These are like pieces of a Lego set. They all fit together and are helpful as you are constructing.
You have inflation, you have GDP, both real and nominal. You have the PE ratio, the Price-Earnings ratio, earnings-per-share, stock market value – all of these things factor in. And frankly, it is okay if you say, “Hey listen, let’s not talk Lego sets, read the book.” Because I think people should read the book. But give us the framework a little bit, if you would, with your financial physics model.
Ed:The financial physics model connects three components of the financial markets with three components of the economy. When we do that, we find that there is an interconnected relationship. As a matter of fact, when I have done this presentation, presentations online, free access to the public in the financial physics section of the website under stock market.
But economists look at this and say, “Yes, the three components on the economic side of the equation, which are GDP, real growth in the economy, plus inflation, is equal to nominal GDP. Just those three factors – real growth in the economy, inflation, and nominal GDP. They tie in, kind of like Lego blocks which you mentioned, with three components of stock market returns – the price-earnings ratio, earnings growth, and then the aggregate of those, stock market returns.
And the two components of the economic side are direct drivers of the two components of the financial side of stock market returns. So basically, there is a very simple graphic that the person could find online. It’s easier to talk about that way. And then a lot of the Crestmont Research articles and charts are built around graphics because I find that color pictures tell a thousand words. That is the reason that both books were printed with color graphs and charts.
Dave:I also wanted to mention that you have a video series which goes through a lot of those graphics, and you explain them in very straightforward language and that is all available free on your website, CrestmontResearch.com. An invaluable tool – you have the eight-minute trailer and then six 30-minute presentations which unpack some of these ideas. And I would say it is must viewing.
Ed:Crestmont Research is an open access academic research, but layman’s level academic research, website. The word academic shouldn’t scare people off. As a matter of fact in some ways it is sort of contradictory to modern academic views, but I think you will find the relationships to be compelling. And in a financial physical relationship, the fact that we have key financial drivers driving the stock market is in itself an insight, because conventional wisdom got developed through the 1980s and 1990s to reinforce the notion that stock market returns are random – the random walk down Wall Street – that long-term returns are constant – that it always reverts back to its long-term average.
And it ignores the fact that valuation matters, because if you do sufficient diversification you eliminate all of that individual stock return and you drive down to just market return. And if that is randomly driven over time then it sets people up for much more of a passive approach to investing rather than taking the more active approach of investment selection, portfolio diversification, and all of the tools and techniques that go around that. One thing, just as a warning, the books and the website don’t offer specific investment advice.
Crestmont’s work starts with principles and delivers the information to help investors understand the environment. The biggest criticism about Unexpected Returns– people got toward the end and said, “Well, wait a minute. You didn’t tell us what to do.” There are lots of folks out there who can tell you a variety of different ways to do it. I think the first step is understanding what you want to do, and understanding the environment that we are confronting, and the principles that drive the market.
Dave:This period of time to the present, arguably, and in Probable Outcomesyou make a great case for it. Actually, in both books you make a great case for there being periods of time where you are going to need to row, versus just set your sails out and let the wind drive you, where a passive approach might work, just putting your sails out and catching the wind, to row, to make any progress, was the prognosis in 2009, as it turns out passive investing was one of the great success stories in this period.
And active investing – it’s almost like the smarter you were, the stupider you looked in this 2009 to 2019 period. I know a number of macro hedge funds that just have not been able to do anything. And I wonder if you might comment on how we understand this last ten-year period. The bear in hibernation may be the best way of understanding it. Can we remain a bear in hibernation indefinitely because of central bank gerrymandering in the natural market processes?
Ed:I would say, theoretically, we can. Over the last almost ten years we have had several things. One, we have continued an unprecedented period of low, stable inflation. That’s good, but it has also been a factor and a driver. The second, we are now in the second-longest period in economic history, since the mid 1800s, the second-longest period of expansion of the economy without a recession. And if we get to next summer, we will become the longest period of economic expansion since the 1850s. Keep in mind, every decade since the 1850s has had between one and four recessions, and since the 1930s, has had either one or two, and it has twice as often had two, rather than one.
So going as long as we have without recession is unusual. As a matter of fact, if we get to 2020 without a recession, the 2010s will be the only calendar decade, ever, without a recession. The reason I mention that is to show how significant it is that we have had this long period of expansion, how we have avoided, and maybe that is one of the reasons we have had generally low volatility in the market, is that we have had a very muted economic and business cycle. So slow and steady. The good news is that slow and steady has kept inflation down, it has helped to encourage the animal spirits in the market to push valuations up with a lot of hope. It has given us a good environment. The key, though, is that people don’t get to invest in the past ten years. They only get to invest in the next ten years. And we are positioned today with relatively high valuations, and investors need to recognize that even if we stay here, even if we go another decade without recession, the question is how much higher can valuations go? And even at these levels, again, you are baking into the total return, a relatively low growth rate with lower inflation, so it is a lower nominal growth rate, and less than half the dividend yield we had historically. So we are positioned for below-average returns, but the question is how this plays out from here. And the vulnerabilities – for people with investment portfolios, they need not stay strictly passive. Maybe passive is applicable for part of the portfolio, just keep in mind there are ways to diversify with the other part of the portfolio, and row rather than sail.
Dave:I also hear you saying that low growth rates, half the normal dividend yield, and we could, actually, end up with a Trifecta there, of lower returns based in increasing inflation. And as you look at the language the Fed is using, or has used in the last 12-16 months, there is certainly more of a concentration on the issue of inflation than there are deflation just a few years ago. If there are any watchwords or any cautions, it seems to be in that area. Whether we have statistical inflation or not is not the issue. The anticipation of, and the psychological responses in the marketplace, end up being the defining factors in terms of market pricing, and the impact of inflation. So throw that into the mix and now you’re talking about significantly reduced performance, correct?
Ed:Absolutely. And if inflation picks up I think one of the biggest differences for the Fed is that there were periods in the past when the Fed targeted price stability and a cap on the level of inflation. Today the new mindset is, a little bit of inflation is good and so they want a certain amount of it, so they are actually encouraging us back toward 2%. And 2% is just versus maybe 1%, which would be much more stable. And actually, we have spent a good bit of time near 1% over the last 5-10 years. The risk is that we break out of 2 and start seeing 3, and the Fed is not addressing it quickly enough.
And we still have some of the factors that maybe led to returns over the last decade that were successful. One of their goals with inflating their balance sheet and lowering interest rates was to promote stock market performance to increase the wealth effect to stimulate the economy. Now they are trying to exit that zero interest rate policy. They are trying to deal with the inflated balance sheet. The Fed hasn’t gotten back to neutral yet. So some of the factors that essentially spiked the punch bowl have yet to leave the party.
Dave:I don’t want to go too far away from earnings-per-share as a component. In your view, I’m curious what impact record levels of corporate buy-backs had on that component in your financial physics model in the last year or so.
Ed:There have been high stock buy-backs. I think when we dig in and look at the offsetting factors, stock issuances, option conversions, etc., it is not quite as dramatic as just the buy-back statistics would suggest. Clearly, there has been some impact from stock buy-backs. Longer-term, the jury is out. Companies are not immune to the impact of valuation decisions. They are buying back their stock at high valuations. It is certainly having a short-term positive impact on earnings-per-share.
The question is, ultimately, are those valuation levels sustained, and if they are not, companies may find that they used up some corporate wealth by overpaying for stock at an inflated period. And so that earnings benefit may ultimately be a give-up in value rather than some type of an alchemy that drives stock market prices ever higher.
Dave:At one point in your discussion on inflation in the book, you say that prices are a great communicator of market conditions. I have had to scratch my head here in the last few years in a unique way. We have had the Bank of Japan, the ECB, the Fed, policies in play between 2009 and the present which have, essentially, created a price control dynamic. Interest rates are a price – the price of money – and they have very definitely been influenced by the central bank monetary policy engagements.
What do we make of prices – and maybe we are refreshingly moving back toward an era where prices matter again – but here in the last couple of years prices haven’t been conveying the information that they used to, have they?
Ed:I think in the past few years, price haven’t, and I think the key thing – this gets back to the analogy about the weighing machine and the voting machine, and this gets back to the reason that Shiller used a ten-year average, and Dodd used a seven-year period to normalize earnings. The answer is, in the short run, prices are not necessarily a reliable signal over just a few years, and there can be periods like the late 1990s that get out of line.
But if we look at the late 1990s and early 2000s as a collective period, most of these periods, we can look at the ’08-’09, which was a correction from excesses from that precede it, and then it was an overcorrection that then righted itself after that period. When I look at secular cycles and then look at signals, I would tend to look at them as multi-year periods, and really, more than 3-5 year periods to be able to get reliable signals.
That is why right now, with valuation high, it is unclear that that price being that high is a reliable signal, because the only other factor that would drive such high valuation. Because once inflation gets low and stable, the other factor that drives valuation is growth – earnings growth or economic growth – and I don’t think right now there is much of an outlook for the level of economic growth, consistently, that it would take to justify current valuations.
In the late 1990s, even the Fed – Greenspan was making several speeches about how he felt we were entering a new era of above-average growth as a result of technology. The Fed expected 4% real growth, about a point over the 3% historical real growth. With higher real growth, because higher growth drives higher values, the level of valuation today would suggest that we are expecting a perpetual 4% or more real growth, and I don’t think anyone is expecting that. Almost every economic forecast expects 2.5% or less, below the historical average.
Dave:Greenspan deserves a medal for his forecasting. I’m not sure if it is the medal that says that he was a genius (laughs) or the guy that missed the most important class in the Ph.D. program. But a new era, what we ended up with was 1% less, not 1% more. It was less than 2% instead of close to 4%. Talk to us a little bit about what may represent a downshift, where we have gotten used to this idea – talk to any financial advisor on the planet and they would say, “Oh, well, average PE should be right around 15 or 16, so we’re not that over-valued here, or we’re very cheap here, relative to that 15-16 price-earnings number.
You make a case in one of your more recent papers, and I really love how you frame it. It’s almost a thought experiment. “Consider these factors,” is how you discuss it. And then you look at the possibility of the whole band moving lower. Instead of high PEs being in the mid 20s, maybe they shift down 5-6-points, and the midpoint no longer being 15 or 16, but the midpoint being 10 or 11. And a low valuation being in the 5, 6, 7 range. Rehearse with us what that is that may represent a big shift.
Ed:The article is titled “The Big Shift,” and it is a thought experiment because it is unlike almost everything else on the Crestmont Research website. It is not based on recognized financial principles. Instead, it seeks to answer what could possibly be causing the increase in earnings that we have experienced over the last several years, and expect in the next year. We have gone from earnings-per-share of less than $100 a share for the S&P 500 to an expectation of over $160 per share next year. That is an over 60% upshift in earnings over a period where economic growth, on a nominal basis, is averaging less than 5% per year. That would be maybe 15% or so over that three-year period.
So rather than say that earnings are unsustainable and they are definitely coming down and that is going to happen, the purpose of that article was to say, “Is there something that could have happened – is there a financial justification for why we saw this perpetual upshift in profit margins? The only thing I could come up with was, because of a series of trade-offs, we do have a period of slower growth. When we have slower growth, the return on investments that companies make when they open factories and they build businesses is lower unless the profit margin increases. Unless there is a trade-off, an upshift in profits, to compensate for the downshift in growth that we have gone through over the last decade.
So the big shift posits, and again I’m not convinced that this is going to happen so it is a thought experiment, but if we are going to sustain the level of profit that we have being presented from companies, $160 a share, it may be because of slower growth. The implication of that, though, is that upshift in earnings will create a downshift in the PE ratio on a reported basis. But the lower PE ratio is consistent with, because when we have slower growth you expect lower PEs. Anybody that has a portfolio of slow-growing companies will find their average PE is lower than a portfolio of fast-growing companies.
So we would all be internally consistent that slower growth could lead to an upshift in profit margins, which would lead to a drop in the PE ratio. But we need to keep in mind that that doesn’t suddenly make stops cheaper. What is means is, the valuation comes down to compensate for the slower growth that is going to lower stock market returns. So when you take all that together, and I would encourage anybody interested in that nerdy discussion to go back and read the article. Basically, it doesn’t change the outlook from mid single-digit-or-below returns on the stock market.
Probably got a little nerdy on you there, David, but I was pretty pumped up about the article when it first came out and, actually, since then, as I have seen profits and profit projections be sustained, I am wondering more and more if that isn’t going to be, ultimately, a valid explanation for an upshift in profits. But it is not going to create an upshift in returns.
Dave:This is one of the things that you have to do as an investor is look at things from a different perspective, and try things out. The thought experiment model that you use in “The Big Shift” is helpful as you are processing explanations of what has happened of an anomalous behavior and what are the reasonable explanations of it.
There is a bunch of things that I would love to visit with you about. I think other things that you talk about that are very important to your “Y” curve effect, is something that if anyone is reading Unexpected Returnsthey should spend some time on. But I think you also illustrate it on the website, as well, that it is the mapping of the relationship between price-earnings ratios and inflation.
The question I have is, can we see an encore performance in the decade ahead where interest rates are influenced by central bank balance sheet expansion, and we have the appearance of price stability as a constant. Again, we have had the conditions that were sufficient to keep things at an elevated level. Can those conditions remain?
Part of what has me asking the question is, just a few years ago it was popular to theorize that China had found a new way, a quasi-capitalism, a command-and-control dynamic where you didn’t have to see market declines, it just required the government to intervene at certain particular points. I think the jury is still out on that. We have yet to see what multiples, trillions and trillions of dollars of credit expansion actually brings about. We haven’t seen any unwind of mal-investment in that space yet.
Do you get the gist of what I am saying? Can it go on forever in a world where the market takes a back seat to the seen hand of government instead of what you and I have been used to, and probably appreciate – the unseen hand of the markets?
Ed:I am a fairly democratic market analyst – other people call it free market, but I call it democratic market – in that I think that the power of individual decisions and individual transactions all working together in the economy, creates all kinds of price signals that maximize the benefit.
I think the China experiment, what we may be seeing there is, what happens when you have a country with a billion under-employed people out on farms, and a significant number of them move into the cities and become productive in factories? That is a unique circumstance that is not taking an evolved economy where everyone is employed or employable at a certain extent, and then trying to improve production beyond that through machinery and through training. China is a bit unique because of its circumstances with moving so many people into the economy and having that surge in growth, and frankly, probably needing government to keep that train on its track.
Can this continue perpetually? I think what we should look for is that our stock market will continue to follow financial principles perpetually, and that we will find that the economic growth is going to drive earnings over time, but the inflation rate is going to drive the PE ratio, when we start with high valuations we get below-average returns. And so from todays’ environment, investors now have an opportunity to protect their portfolios through rowing techniques, and this isn’t really the right time to sail, but by the way, there is nothing wrong with sailing. The key is to just recognize that the expected return under modern portfolio theory would say that is single-digit, 5-6% or less returns from stocks, and clearly, less than that for bonds.
Dave:I wrote a book a few years ago on legacy, and in your book you capture what is a generational return. You define that as capturing a 20-year period within the market. We talked about how there is no average return that you could expect, but as we did discuss earlier, most investors start saving, their investing, in accordance with their life and work cycles, and it is regardless of the market value at the time.
What is the best-case scenario? Is that what you are describing now, where an investor can be aware of the secular cycles, can feasibly benefit from multiple cycles, maybe even improve their outcomes by learning and applying the valuation metrics you discuss and mitigating risk at certain points in the cycle and extending the sails and capturing as much wind as you can at other points.
Ed:I would say that is probably one of the key messages to come out of the books as well. It’s not the environment you are in, but what you do about it, that has the biggest impact. I think that just because we talk about valuations being high and returns being below average, and being destined to be below average, it doesn’t mean that investor returns are destined to be unsuccessful. The good news about a low inflation environment is that costs are generally rising more slowly than they were back in a higher inflation environment, so investors should expect a lower return.
But this is also an opportunity, because when returns are running single digits rather than, like the 1980s and 1990s, 17% on average per year, the extra percentage point or two that can be received from having good investment decisions good investment help, can make a big difference for compounded returns over time. That is where here, the little decisions can have a big impact, unlike back in the 1980s and 1990s when passive investing worked and getting an extra point or two on top of your 17% really didn’t have much of an impact.
Dave:I love the language that you use – higher return requirements – to describe the market actually selling off to a level where prices have the opportunity to then appreciate and offer more impressive returns. You put a lot of emphasis on this idea of bull markets only being able to advance from a low valuation, bear markets commencing from high valuations. Have you figured out a way to communicate this so that investors don’t merely extrapolate current trends indefinitely?
Ed:In my mind, it is really discussing the reconciliation principle. There is an article by that name. The reconciliation principle says that returns are derived from earnings growth, dividend yield, and the change in the price-earnings ratio. And as we talked about, anyone’s forecast, or as we develop our own outlook, we need to have reasonable expectations for earnings growth, change in valuation, and dividend yield. And in this environment, and I think everyone agrees that we have above-average valuations, it should be readily recognized that with above-average valuations, and by the way, everyone knows we have well below-average dividend yields.
So the only way to expect a continued strong return from the stock market is to expect an expansion of valuation, and I think when we talk about that it begins to be reminiscent of the late 1990s when the belief was that returns would continue because as the price-earnings ratio went out of the 20s, into the 30s, and ultimately, into the 40s, people thought that there was some reason that could perpetually continue. So I would hope that people would reflect back on the financial lessons of that period and the financial lessons of the 1980s and 1990s, why returns were so good. It was because the price-earnings ratio started in the single digits.
Remember back in the early 1980s when the price-earnings ratio was around 6 or 7, and dividend yields were near 5%? That occurred because we had very high inflation at the time. So sometimes I think the challenge of explaining it in an elevator ride is that you have to first start the conversation with getting past the conventional wisdom that stock market returns are random and they always go back to average, explaining that they actually have a fundamental driver, and then try to put the pieces together in the Lego blocks to put that in perspective.
Just one quick promotion on the video because it’s an open access free video but I think it is a fun way to explain a lot of these concepts. I don’t think that viewers are going to find it to be very technical, and it certainly is not as geeky as some of the things was have talked about today. As a matter of fact, even kind of tongue-in-cheek and cute, it includes a two-headed dragon and a couple of gremlins, and I think they are very helpful actors in the story.
Dave:Crestmont Research continues to put out some very insightful and thought-provoking ideas. I look at Unexpected Returnsand Probable Outcomesas foundation stones if someone is interested in building an understanding of financial history and the mechanics within the markets. These are books that you cannot neglect – cannot neglect.
Fascinating to me is that you are both the research guy who likes numbers and the analysis, but also have been for many years a practitioner. In other words, the investment manager business, up until recently, was a part of your world. So you have had the opportunity to be the decision-maker and see the consequences of good and bad decisions meted out in real time.
That’s good, because sometimes just an academic approach is just an academic approach. It works well within the ivory tower, but not necessarily on the street. I wonder, as you have encountered clients, as you have talked to people through your years of experience, what are the most dangerous assumptions an investor makes as they approach the markets?
Ed:I think it’s that misunderstanding that market returns are random, and that the long-term average is reasonable from any starting point if you wait long enough. I think those two misunderstandings have caused investors to inappropriately structure portfolios and to not anticipate the inevitable. We have seen it play out of the last 20 years when valuations got as high as they did in the early 2000s, it destined the 2000-2010 below-average returns, just as we appear to be destining the 2020s.
Unless valuation comes down significantly, which we don’t hope happens in a short period because that means the market goes down a lot in a short period, and that is not a good thing for current investors. New investors would cheer that, but current investors would take a lot of pain in that circumstance. But it looks like we are clearly, from here, destined for another decade of below-average returns, but that just means it is just a continuation of winter. It just changes what we do, it doesn’t change the potential for success.
Dave:There is this idea of teaching a man to fish versus giving him a fish, and that is what you said you have attempted to do in Unexpected Returnsand Probable Outcomes. You don’t have a laundry list of things that you recommend. At the end of the day, you would prefer to promote proper thinking about the markets and thoughtful analysis which can then be personally applied and tailor fit.
I am curious – and you may not be comfortable answering this – but I am curious how you translate, for yourself, the wisdom in Unexpected Returnsand Probable Outcomes. Here we are in the fall of 2018, valuations are very high in the stock market. We put in a low in bonds and bond yields in 2016. They have been rising ever since. These could be tectonic shifts, or we could be at a sustained level, the extension of the hibernating bear. You have to make choices, Ed, and maybe you could share with us what you think some of your choices are, with the caveat that this is the conclusion that you have come to just for yourself.
Ed:Part of it is that about ten years ago I made a shift from working with a more passive portfolio to employing that portfolio into a lifestyle business. I have been in Oregon for the past ten years, bought some timber property, and have since expanded that into including cattle. And so most of the financial assets I would have balancing those real assets would be in this environment – zero coupon bonds, retirement accounts, which counter-balance the real asset side of the investment portfolio.
With stock market valuations as high as they are today, I just find that the risk/reward is not compelling, and so my exposure to the stock market is that I don’t, at the current time. Again, I am not advocating this for everyone. I think the key is how you structure a portfolio and where you approach it, but right now my exposure to the stock market is very minimal.
If I went back and took the time, part of the reason is that I have devoted a lot of my time to the lifestyle business, to the cattle and the timber and some other habitat initiatives that I am working on. But if I had the time I would be looking for the types of stocks that were a good value, that provided better yields, that had some downside protection, ways to approach the stock market with the types of securities or structures of portfolios, or overlays to portfolios, that provided that type of protection.
When I give presentations about this information the question often comes up, “What would you do?” I, in no way, suggest that someone should exit the stock market. This is a great time to be invested in the stock market. The key is to do it in a way that is prudent for the environment. Winter is a great time to be farming, just make sure you plant the right crops. Don’t expect those tomatoes to come up.
Dave:(laughs) I don’t know that everybody, necessarily, wants to put on a pair of cowboy boots and go punch cattle in the afternoon, either. But as a lifestyle business I can imagine that it is incredibly gratifying to you. So, between that and timber and other things, I like the balance between productive assets and financial assets, real things versus paper promises. It is a good mix.
Well, if I’ve said it once, I’ve said it two or three or four times, start with Unexpected Returns: Understanding Secular Stock Market Cycles.It is a must-read. And if you want the Reader’s Digestversion then by all means go to CrestmontResearch.com and look at the video series that Ed has put up there, generously, for free, and begin going down that rabbit hole.
I think very quickly you will find the necessity of reading Unexpected Returnsbecause it is compelling data, it is compelling information. I can’t tell you how many aha moments I had reading Unexpected Returns, and then also with Probable Outcomes, your book from 2010 which puts together some of those Lego pieces in a way that was really helpful, really helpful.
So Ed, thanks for being kind and generous with your time today, and also with sharing your insights and your published works and continuing to do that on your website.
Ed:Thanks, David. I really enjoyed the discussion.