September 7, 2013
In Probable Outcomes, Ed Easterling expands upon his framework for analyzing secular stock market cycles that he outlined in his first book Unexpected Returns: Understanding Secular Stock Market Cycles. A secular stock market cycle can best be defined as a sustained period of above-average or below-average returns. For example, the last secular bull market in the US took place between 1982 to 1999. During secular bull cycles there is generally a strong upward movement in valuation as measured by P/E that generates outsized returns. I’ve read in numerous books about the existence of secular market cycles. However, I had never seen an adequate explanation for their existence. Probable Outcomes was the first book that I’ve read that convincingly made an argument as to why they exist. The key insight developed by Easterling is that inflation or deflation is the key driver for stock market cycles. A rising price level (inflation) or a declining price level (deflation) leads to lower P/E multiples and lower returns for stock investors. Conversely, a return to price stability leads to higher valuations and ultimately improved returns.
From a macroeconomic perspective, I continue to believe that the unprecedented quantitative easing being pursued by the US Federal Reserve will ultimately result in significant inflation. In my view we could easily return to the inflation last seen in the 70s. Whether you agree with my macro view or not, as an investor a key question you need to ask yourself is how will inflation impact my investment portfolio. I think it’s generally accepted across the investment world that equities provide a good hedge for inflation. Unfortunately, Easterling shows that this is not the case. Although inflation does increase nominal earnings, the offsetting impact from a higher required rate of return results in valuations actually compressing during periods of high inflation. Essentially, nominal earnings growth is not enough to offset the impact from the use of higher discount rates that reflect higher rates of inflation. Easterling states specifically:
Since stocks are financial assets, higher inflation drives stock prices lower. The effect of inflation on the discount rate is greater than the effect of the inflation rate on earnings. The inflation rate does not transfer completely into earnings growth.
If you look at US equity returns during the highly inflationay 70s, Easterling’s viewpoint appears to be correct empirically as well. The second major point that Easterling highlights is that valuation as measured by “normalized” P/E ultimately drives total returns for an investor. If you invest when the market is expensive your future returns over almost any time period will most likely be poor. Any value investor would agree that your total returns are a function of the price you pay for a security. Easterling is simply applying the same principle to the broader market vs. a single security. Typically there are natural bounds for “normalized” P/E. For the US equity market, valuation tends to bottom-out at a 5x P/E and peak out at 25x. The one glaring exception was the dotcom bubble in 1999, when the US equity market peaked at a 40x P/E valuation. Unfortunately, investors are still paying for this egregious overshoot in valuations almost a decade and a half later.
You might be wondering what exactly is meant by the term “normalized” P/E. Essentially the economy goes through cycles, which ultimately flows through to earnings of actual companies. If you were to calculate P/E based on depressed earnings during a recession, you might find that the market was still expensive despite a significant market decline. Conversely, you might find the market cheap based on P/E due to high earnings growth and high margins at the peak of an economic expansion. The following excerpt from an article on gurufocus.com explains why the market looked expensive in Q1 2009, but turned out to be an excellent “buying” opportunity.
The highest peak for [trailing twelve month] P/E was 123 in the first quarter of 2009. By then the S&P 500 had crashed more than 50% from its peak in 2007. The P/E was high because earnings were depressed. With the P/E at 123 in the first quarter of 2009, much higher than the historical mean of 15, it was the best time in recent history to buy stocks. On the other hand, the Shiller P/E was at 13.3, its lowest level in decades, correctly indicating a better time to buy stocks.
A “normalized” P/E calculation attempts to adjust for the economic cycle. A well known normalized P/E conversion is the one developed by Robert Shiller, which he popularized in his book Irrational Exuberance: (Second Edition). Essentially, Shiller calculated earnings for the market by taking a ten year average. Thus, any deviation from the underlying growth trend in earnings would be smoothed out. Shiller believed that a decade was long enough to encompass an entire economic cycle. In Probable Outcomes, Easterling critiques the Shiller approach and provides an alternative. Interestingly, Easterling’s normalized P/E calculation produces similar results to Shiller’s calculations despite taking a different approach. Easterling actually uses a forecasted value of GDP to estimate EPS. After deriving his EPS estimate, he then calculates potential return scenarios based on the outlook for inflation or deflation.
Easterling makes the case that the US equity market is still in the throes of a secular bear market. Thus, investors should be focused on investments that provide absolute returns. The only glaring weakness in the book is that he doesn’t go into further detail about the types of investment strategies that work in such an environment. In my view, Vitaliy Katsenelson who also comes to the same conclusion about the current secular bear market in his book Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance), provides an actual framework that investors can follow. You can see my review of the book here. However, my complaint is a minor one as the focus of Easterling’s book was on defining secular market trends and the reasons for their existence. On both fronts he does an excellent job of laying out his argument in a logical and well researched manner.
As the title of the book suggests, Easterling outlines potential outcomes for the market over the next 5, 10 and 20 years. The first point he raises is that there are two major uncertainties facing the US equity market. The first uncertainty is that the real rate of GDP growth which had historically been 3% has decelerated to 2% since 2000. If real GDP growth doesn’t return to its historical levels, the outlook for long-term earnings growth is quite negative. The second uncertainty is whether US investors will face inflation or deflation. As mentioned earlier, any move away from price stability will cause a decline in the market P/E multiple. In a worse case scenario either inflation or deflation would cause the market P/E to fall and earnings growth could disappoint due to lower than expected GDP growth. Easterling’s book highlights the various scenarios that investors in the US equity market are facing. More importantly, he gives you the tools to determine your own long-term outlook for the US market based on your own assumptions. I would highly recommend the book for any serious student of equity markets. Although he focuses on the US equity market, the principles in the book could apply to any equity market globally. An understanding of secular bull and bear markets will help you to become a better investor. I think Probable Outcomes is well worth its purchase price. Easterling does an exceptional of job of clearly an succinctly laying out his argument as to why the current secular bear market in US equities still has a long way to go.
Tags: Shiller PE