Update September 24, 2016
Is a horse race a sound
market indicator? Part 2
In this part, I look at HSBC’s
analysis of whether equities are overvalued if stagnant and explain my view.
The key point is highlighted by HSBC in
its white paper, when it explains that bond yields are low versus data since
the 1800s for the UK and the US, and data since the 1700s for Holland. In
fact, yields have only been so low on two previous occasions, both times in
the aftermath of financial crises: the Latin American debt crisis of the
1890s and the Great Depression of the 1930s.1
Yet its bearish equity-market analysis
implicitly assumes normalisation of real interest rates, nominal interest
rates, and of the term structure. Whilst it’s reasonable to expect some
degree of normalisation for today’s historically low rates, HSBC – as well
as the bond market – believe that a full mean-reversion is very unlikely.
The White Paper then diverts into an
academic analysis of bond yield drives that I’d regarded as a red herring –
unless they believe bond yields will never normalise again. They describe it
as a “convergence of factors points to the rate environment remaining
lower-for-longer, a view which markets have largely come to accept.
Concurrently, the HSBC paper goes on to
say, when interest rates do start to rise, “the cycle seems likely to be
slow and low.” Such an outlook, for structurally low interest rates,
impact perspective returns for asset classes across the risk spectrum. For
equities in particular, it implies that what it was under higher
interest-rate regimes, during the 1970s-1980s.2
This tends to ignore economic history
dating back to the earliest records of Sumerian civilisation – it’s asking
for a huge leap of faith to insist on a seismic shift that totally
disconnects today’s world from 5 millennia of human history. HSBC also
dismisses the fact that today’s equity markets contain higher equity
premiums, which can easily be proven measuring by e.g. Jensen’s Alpha3 and
their failure to recognise the reasons behind this.
There is quite a significant body of
commentary that explains how the need to generate income or growth in a ZIRP
/ NIRP environment has led to enforced equity re-rating. Investors who have
been forced to abandon their normal risk preferences and behavioural
investment studies are extremely well aware of this.
Whilst the HSBC white paper seems to
start from a partial point of view, seemingly committed to defending equity
valuation levels, it takes a quantum leap in its attempt to measure the
prevailing market discover rate. This involves some significant assumptions:
“For the US, we assume a rate path broadly in line with the Fed’s forecasts,4 while
in Europe we assume that the ECB will persist with its current accommodative
policy stance into the near term. Interest rate rises are consequently
delayed, as we expect headwinds from the financial and Euro crises to
continue weighing on the rate outlook into the medium term.”
They admit that this “encapsulates the
notion of a “slow and low” interest rate cycle with divergence between major
central banks.” And that “assuming a more hawkish rate trajectory creates a
larger capital loss for risky assets as they are forced to de-rate.” That’s
as maybe, but it also assumes Goldilocks is alive and well and that not
too hot, not too cold, but just right will manage to prevail as
Macro-economic conditions for the next decade.
This would truly be a “great
moderation”. They also assume at 4% reverting to cyclical norms and a
current dividend pay-out ratio of around 45%. They even assure a rate of 2%
for European real dividends over the near term. Again, Goldilocks would be
The linkage between such benign
interest-rate assumptions of consistent dividend growth for a decade strikes
me as wishful thinking, tempered by the authors’ rejection of even more
fanciful growth claims. In short this attempted analysis ignores causative
relation and the possibility for any shock – it’s a very elegant constructed
arithmetical model, yet doesn’t reflect any plausible reason.
This explains why they reach the
conclusion, “On this basis, in contrast to the conclusion implied in US
bonds, it seems difficult to argue that equities are very overvalued today.
Even in our conservative scenario, US equities look fairly valued, whilst
European equities look cheap – as do global equities relative to government
In fairness, they do set out to answer
the question Are equities overvalued if growth is stagnant? But in
doing so, they pretty much recognise that their view owes nothing to
fundamental value and everything to the freakish conditions created by
policy. This undermines their own argument that prices aren’t primarily just
a reflection of
Frankenstein’s monetary policy
equivalent - their view of the next decade that is ultimately contextual,
admitting that as the economic environment evolves, their assessment of
available market returns must also change.
So this 10-year view is based entirely
on factors today that are hugely changeable; except that “Today, one of
market participants’ crucial concerns is of a long-term stagnation in
economic growth going forward, which is also likely to create problems for
the corporate sector. A lacklustre macro picture would make it difficult for
corporates to generate decent free cash flow and dividend growth to reward
The HSBC’s justifications revolve
around a flawed Macroeconomic understanding that ignores the role of
excessive private debt in cyclical stagnation. Sadly, they fail to address
this in their paper, which is its contrast flaw – if you don’t identify the
single greatest prevailing macroeconomic driver and capital market issue,
you won’t infer the right answer.
In fairness, having gone out on a limb
to justify the unjustifiable, they half admit this is their conclusion “Not
overvalued, but we are walking a tightrope.” They state that “A lack of
generous market pricing across conventional asset classes implies that we
are currently in a low-return world. However, our research does not indicate
that equities are overvalued, even under stagnant growth assumptions.
Relative to the low returns available on cash or government bonds, we
believe equity markets continue to offer fair-to-attractive compensation for
However, they sound unconvincing,
admitting that the views are all based on a very short term focus. “We do
not believe equity valuation can legitimately be assessed according to a
fixed benchmark. It must be contextual […] the assessment of equity
fair-value relies heavily on how interest rates and corporate fundamentals
will evolve. Our approach to valuation is based on the present value
relationship linking current prices and economic fundamentals to extract
an implied premium (excess return) for equity market.”
Even though they are absent of an
understanding of high debt cyclical stagnation, they admit that their
roseate view may well be ignoring the dangers that the future holds. “We
continue to believe that we are walking a tightrope between forces of
“secular stagnation” on the other hand and a combination of better growth
and higher US interest rates on the other, with market volatility likely to
remain episodic. This combination of heightened macroeconomic uncertainty
and low asset-class returns poses a challenge for investors. In this
context, we believe that a focus on active asset allocation has never been
Amen to that – but I wonder why such a
reasonable conclusion was preceded by such an arithmetically eloquent
justification of the unjustifiable. HSBC seem to think equities aren’t
overvalued because looking out from very unsound foundations today we can’t
see the cause of a major correction happening tomorrow. But then markets
rarely can, so I don’t believe that is the same as saying equities aren’t
expensive. At some stage equities will correct.
Until then, whether that is tomorrow or
in 10 years’ time, equity returns are likely to disappoint. As a risk –
adjusted value advisor, that implies to me that equities are, in general,
too expensive to invest in. Most other asset classes are and valuations are
both contextual and relative.
But for now I’d rather keep out of all
the dung in the farmyard, rather than trying to pick a favourite and that’s
why I’ll be very circumspect with my equity appetite for equities this St
4 Fed Summary of Economic Projections, March 2016
Update September 17, 2016
Is a horse race a sound market
indicator? Part 1
In the world of finance, you hear a lot
of sayings and superstitions. I even heard someone say “buy Apple shares”
once. But there’s one old adage that might actually have some substance.
The saying I’m talking about is Sell
in May and go away, buy again on St Leger Day. The day in question is
the St Leger Stakes, the final horse race of the English Triple Crown. It
takes place in September and is the traditional end of the season. The
saying refers not necessarily to the specific date of the race, but
generally staying out of the market during the less-profitable summer months
and investing fully in the winter.
Of course, it’s not always true – it’s
quite possible that returns can be made in the summer months. If we average
the S&P’s monthly performance since 1950, we can see there is a definite
trend in favour of walking away from the market in May (see chart 1).
Chart 1 -
Source: ETF.com & S&P.
There’re also some plausible causative
factors. For example, in the UK there is often a lull because of the new tax
year; whereby activity increases towards the end of the previous fiscal
year, pulling forward buying whilst delaying selling. Of course it also has
a lot to do with thin volumes because of the summer holidays.
But this year we should also focus on
equity valuations too as they’re the key defining point behind where we’re
at. A recent white paper by HSBC asked, “Are equities overvalued?”1 It
begins by referencing the father of value investing, Ben Graham, who
famously likened the stock market to a voting machine in the short run and
to a weighing machine in the longer run. In other words, over a short period
of time equity prices may move away from fundamentals, but over a longer
period there’s not such a large gap. Current valuations are in no small
measure a reflection of unprecedented policy, the “sugar high” that, when it
wears off, will give rise to market weakness and volatility.
In the white paper, HSBC disparage as
bearish the view, “The idea that there should be mean-reversion back to
long-run averages is typically made with reference to equity valuation
metrics.” To illustrate this the paper took a selection of popular price
ratios against their historic average readings: below are the 3 that have
the greatest very long term substance (see table).
HSBC admit, “Many of these metrics
remain well above historic averages. Using a long, 100-year time series to
benchmark these readings adds further plausibility to this argument.”2 I’d
prefer to note that the 3 key metrics show an overvaluation of 89% which
becomes 90% if Warren Buffet’s favourite valuation metric, Market
Capitalisation to GDP, is added to the mix. I’d excuse normal P/E ratio as
less relevant because the data quoted by HSBC only date back 1971; a very
misleading data subset.
HSBC explain that the “Shiller PE,
for example, is a widely-followed metric, which compares the current
equity price to smoothed (10-year) earnings. Academic studies have evidenced
a strong link between high Shiller PEs and weak future long-run equity
it’s reading over 24, a situation which Professor Shiller argues has
occurred only infrequently (in 1929, 2000, and 2007) and has each time been
followed by a market collapse.
As Shiller wrote in the New York
Times last year:4
It is entirely plausible that the
shaking of investor complacency will …. take the market down significantly
and within a year or two restore CAPE ratios to historical averages. This
would put the S&P closer to 1,300… and the Dow at 11,000. They could also
fall further; the historical average is not a floor.
After the recent market rout and rapid
rebound, the S&P is trading at around 2,050 and the Dow at around 17,500. If
Professor Shiller is right, there is significant further downside to come
and investors need to be extremely wary of the outlook for equities.
The market capitalization-to-GDP ratio
is also significantly ahead of historic norms. HSBC also explain Tobin’s Q –
a measure widely followed by macroeconomists, which charts firms’ asset
value against current market value. Current levels are also showing an
extreme reading relative to their 100-year average.5
Their summary of the data is, “The
point is, as Professor Shiller eloquently puts it, that equity price ratio
analysis leads many economists to conclude there are predictable further
losses ahead. The assumption is that what goes up (“unsustainably”) must,
eventually, come down.”6
In similar vein Coram’s James Sullivan
recently noted that the last time that UK leading economic activity
indicators were at current levels the FTSE was below 4,000!
However, HSBC does not believe the
issue is quite so straightforward. They argue that ZIRP or NIRP changes the
inputs that have to be used for equity valuations which the white paper lays
out – HSBC then construct their own case by the classic Gordon growth model.7
Relying on an equity valuation model
that could well be inappropriate, they also make an assumption that
“government bond yields have not behaved like classic sine waves
historically. Rather than mean-revert neatly, bond yields have historically
alternated between phases of stability coupled with temporary mean-reversion
and significant “jumps”. These jumps coincide with shifts in the economic
That’s all very well, but it ignores
the clear long cyclicality of interest rates underlying shifts in equity
valuation parameters. Adjusted for these factors bond yields are, in my view
actually quite consistent, other than the scales of rate blow-outs in the
1970s and 1980s, which are explained by executing markets at the time
Historical US Government Bond Yield
Chart 2 - Source: HSBC.
Historical UK Consol
Chart 3 - Source: HSBC.
One key question that will impact
equity prices is whether bond yields have pulled forward the low point or
could it still be as much as 10-15 years ahead of us. I believe that this is
the key question to answer, although I concur with HSBC that bond yields are
“very low relative to the last 30 years, meaning the phase of bumper asset
returns we enjoyed since the 1980s is over and, mathematically, cannot occur
again from current levels.”10
Therefore, the importance of bond
yields is that, despite HSBC’s views, ZIRP and NIRP are key factors in
equity valuations and this support will ultimately be removed. Accepting
this, trying to justify valuations at today’s levels seems like a futile
process if we agree that:
1. Equity valuations are vulnerable to
normalization of interest rates that could start to occur at any time in the
next decade or two.
2. Until then equity returns are likely
to be disappointing anyway.
Consequently, I think that the key
valuation issues are that equities are expensive today because at some
point, which may or may not be imminent, a major equity correction is
inevitable and until then equity returns will be disappointing – like
pennies in front of a giant bulldozer? To me, that implies equities today
HSBC on the other hand seem more
interested in the intellectual exercise of justifying today’s valuations is
today’s context and therefore disproving that a significant correction is
imminent. This is interesting but, for me, less useful.
In Part 2, I explain why.
3 e.g. Campbell and Shiller (1997), Valuation Ratios
and the Long-Run Stock Market Outlook, Journal of Portfolio Management,
7 Gordon (1959), Dividends, Earnings and Stock Prices,
Review of Economic Studies
8 Bansal et al (2003), Regime-Shifts, Risk Premiums in
the Term Structure, and the Business Cycle, Duke University Working Papers
Update September 10, 2016
The beginning of the end of Austerity? Let’s hope so
After all the promises of several governments to “save, invest and
the enactment of laws to reduce deficits, it seems that all this hard talk
of austerity is turning out to be a load of hogwash.
In June of this year, economists at the
IMF – the world enforcer of austerity – published an article questioning its
own approach, stating:
Austerity policies not only generate
substantial welfare costs due to supply-side channels, they also hurt
demand—and thus worsen employment and unemployment.2
A month later, the UK’s incoming
Chancellor of the Exchequer, Philip Hammond, indicated a scaling back of
predecessor George Osborne’s book-balancing programme.3 Then,
consistent with two years of the Italian government speaking out against
austerity, its economic development minister, Carlo Calenda, spoke in August
of how it was “fighting to change” the 2017 reduction target of 1.8%, set by
the European Commission.4
It seems that, in Europe at least,
cracks are beginning to form in the grand plan to reduce government debts.
And about time too!
Frankly, austerity, fiscal
responsibility, balancing the books, however you want to label it, has
been one of the great disasters of post-GFC policy. And that’s saying
something, when you consider that it shares its infamy with quantitative
easing and negative interest rates.
The whole idea behind austerity comes
from the governments’ apparently sudden realisation that they were cranking
up massive public deficits through borrowing. This particularly came to the
fore when, in some cases, public money was used to stop the banking system
from collapsing under the weight of its own bad loans.5
So it makes sense that governments
offset these massive costs by tightening their belts to the point that they
bring in more money than they spend, right? Wrong.
A government’s balance sheet is in no
way the same as that of a company or an individual’s credit card bill. The
belief that it is similar betrays a total misunderstanding of what money is
and where it comes from. Governments create money by borrowing from banks,
so bank notes are in fact a collection of IOUs. If you’ve ever looked at an
English bank note, for example, you may have noticed the Governor of the
Bank of England’s signature and a promise to pay the bearer the sum of the
So, if there were no national debt,
governments wouldn’t have to borrow from banks. The banks would then have to
create all the money themselves through private loans. The problem is that
there simply aren’t enough private borrowers for the banks to do business in
Even if we disregard that reality, if
you try to cut national debt you’re actually reducing demand in the economy,
which then reduces national output because firms cannot sell enough. Three
countries whose governments have recently run a surplus – Chile, Denmark and
Sweden – have seen a reduction in GDP and an increase in unemployment during
periods of belt-tightening (see chart 1).
Chart 1 -
This reduction in GDP highlights the
nonsense that has been circulating the corridors of the European Commission,
the ECB and the IMF over the past seven years. Their focus is on reducing
public debt, seemingly irrespective of the cost to a country’s social and
physical infrastructure; yet they use the percentage of public debt to GDP
as the main measure.6 That’s
the economic equivalent of jumping at shadows; because both debt levels and
GDP figures are moving variables. So if, as in the cases of Chile, Denmark
and Sweden, the government is able to bring in more money than it spends and
GDP shrinks, the debt-to-GDP ratio will not improve – and may even worsen.
In fact, economist Ha-Joon Chang
recently pointed out that in the now infamous case of Greece, the result of
5 years of austerity is merely more public debt as a proportion of national
output than before (see chart 2).7 So
what we’re looking at is a situation whereby, not only is the policy of
austerity flawed, but so is the way of measuring success – or, more the
point, the lack thereof.
If we take our minds away from the
mind-set of central banks and the IMF for a while and instead apply some
basic logic, it seems a fairly straightforward statement to suggest that
governments receive their income from taxes, such as corporate and personal
income taxes, sales and property taxes.
It’s also not particularly
controversial to say that - as has happened in Greece - if a government
raises corporate and personal income taxes and cuts the minimum wage (by
and public sector salaries,9 as
well as increasing sales tax up to 24%,10 businesses
and families have less money to spend. Not only that, unemployment tends to
increase as companies either can no longer afford to or feel nervous about
committing themselves to employ – as has happened in the worst-hit Eurozone
countries (see chart 2).
Chart 2 -
Consequently, investment and
consumption drop and the economy shrinks. That in turn brings in less
corporate and personal income and sales tax revenue to the government. Hey
presto, that’s where Europe is now.
The solution to this is not so complex
either. In a nutshell, governments need to put money back into the hands of
the people. There are several ways to do this. My IDEA Economics
<http://www.ideaeconomics.org/> colleague Michael Hudson talks of society’s
rich history of debt jubilees,11 used
to wipe the slate clean and recharge the economy. As he says, “Debts that
can’t be repaid, won’t be repaid,” so a cancellation removes the shackles.
There’s also the possibility of
actually increasing government expenditure on important services such as
health, education, digital and physical infrastructure. This would provide a
long-term economic climate where the private sector is able to invest and
spend and thus bring in more tax revenue for the government to reinvest. Of
course that depends on the public sector using the money on its people,
rather than wars.
In the meantime, we can apply pressure
through reasoned argument until the penny/cent/yen eventually drops and the
vicious circle is turned into a virtuous one. My fear, though, is that this
will be ignored and it will take another huge economic crisis to trigger
such a rethink.
1 Then UK Chancellor of the Exchequer George Osborne’s
2010 Budget Speech,
2 Jonathan D. Ostry, Prakash Loungani & Davide Furceri,
Neoliberalism: Oversold? Finance & Development, IMF, June 2016
Thailand: Solid GDP results – but can they continue?
In Mid-August Thailand’s
National Economic and Social Development Board published GDP figures for the
2nd quarter of 20161 –
and they were impressive.
The Land of Smiles’ production was up
3.5% on Q2 of last year, following on from a year-on-year increase of 3.2%
in Q1. This is particularly indicative of the strength of Thailand’s economy
for two reasons: its performance in comparison with major economies; and
because the country has an export-oriented economy.
For almost two years, production has
been increasing at a faster rate than Australia and has recently begun to
outperform the US (see chart 1).
Chart 1 -
Sources: NESDB, St Louis Federal Reserve, ABS.
Exports account for over 69% of the GDP
The country mainly exports manufactured goods (86% of total shipments) –
particularly electronics (14%) and vehicles (13%). Agricultural goods,
mainly rice and rubber, represent 8% of the export market.3 The
kingdom’s major export partners are China (12%), Japan (10%), the United
States (10%) and the European Union (9.5%), machinery and equipment (7.5%)
and foodstuffs (7.5%) being the most important.4
In this poor global trade environment,
Thai exports have suffered, like those of most other nations. Exports from
Thailand decreased slightly by 0.1% year-on-year to USD18,150 million in
June of 2016 (but not as bad as market expectations of a 2.02% decline)
following a 4.40% drop in May, marking the third straight month of
year-on-year falls. Outbound shipments shrank to China (-11.9%), followed by
Japan (-3.8%). However, in contrast, exports were up to the US (+4.7%) and
From January to June 2016, exports
increased by 5.8% in terms of price and 5.2% in value compared with the
first half of 2015 (see chart 2). Although this was somewhat to do with
currency values: for example, the Baht, in the first half of this year, was
6.4% stronger in H1 2016 than in H1 2015.5 In
fact the volume of exports in H1 2016 was in fact slightly down (0.1%) on H1
2015 (see chart 2).
Chart 2 -
Source: Bank of Thailand.
Exports in Thailand averaged
USD9,648.32 Million from 1991 until 2016, reaching an all-time high of
USD21,227.12 million in August of 2011 and a record low of USD1,997 million
in February of 1991.6 Although,
when looking at this 25-year period we have to take into account that Baht
values have fluctuated some 116% over this time.7
So against a very difficult multi-year
backdrop, that worsened significantly during H2 last year when China’s
slowdown started to have a greater impact,8 exports
seem to have stabilised; yet they remain vulnerable and this puts pressure
on the other drivers.
Also the results are very impressive in
view of Thai disinflation - there’s very little inflation component to the
GDP growth. It’s much more akin to ‘real’ growth.
Chart 3 -
Source: Bank of Thailand.
What’s more, the consumption component
of GDP is also challenged – high consumer debt, especially in the lowest
income quintile9 and
also the lowest incomes facing headwinds because of this year’s drought
around 42% of the Thai workforce is still in agriculture11)
declined, so consumption contribution to GDP remains difficult and lower
weak exports also constrain the private investment component of GDP.
The two bright spots had been tourism
and the public sector investment and expenditures. Although the stability
expected following the referendum should be seen as a positive towards
enabling the NESDB’s revised annual target of 3%-3.5% growth13 -
which given that Thailand is currently experiencing deflation, is a real
challenge. It should also allow the government to continue to focus on
implementation of its infrastructure plan without too many distractions.
However, the news of attacks in tourist areas that have left several people
dead and scores injured since mid-August could be a real challenge to the
tourism component unless this can be shaken off quite quickly. If not, that
would be further pressure on public sector investment to raise GDP. Whilst
the NESDB claims that the explosions are unlikely to affect economic growth,14 it’s
far too early to know or even predict.
On the bright side, the acceptance of
the new constitution through the referendum, clears the path to implement a
lot of the investment. The fear was that with a negative referendum result,
there would have been distractions to the implementation of the investment
That said, I agree with Kasikorn Bank
director and head of market & economic research Kobsidthi Silpachai’s
analysis when he said that, now we have made the step towards a new
constitution, in the coming sixteen months leading up to an eventual general
election in Thailand, the economy will probably continue to have the same
kind of economic activity dependency on both government spending and
That dependency on two main variables
means, despite the relatively good results, we cannot too carried away.
2 World Bank
3 TradingEconomics.com, August 2016
11 World Bank
12 Thailand: consumption the weak link DBS Group
Research 25 January, 2016
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