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Bear facts – Heed metrics that drive rather than those that are merely passengers

15/04/2015

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

In stockmarket terms, Albert Edwards is more of a bear than Paddington, Rupert and Yogi combined. So when Societe Generale’s highly regarded global strategist touches upon the strength of US equities – as he did in his research note ‘Draghi seizes crown from the bubble-blower eextraordinaire Alan Greenspan’ – you can be certain he is not suggesting there is any sort of happy ending in prospect. 

Edwards was pointing out that, over the past six years, the S&P 500 has gained more than 200% – the benchmark index’s third-strongest six-year showing since 1900. He then mentioned two years guaranteed to make any investor wince, intoning: “Famously, the two others, 1929 and 1999, did not end well.” Cue ominous roll of thunder … 

Actually, hold the thunder a moment because Edwards had another fact for us – we are currently enjoying one of the longest periods not to have seen “even a measly 10% correction”. The 800 trading days racked up at the time he was writing has again only been exceeded twice – this time in 1999 and 2007 – “two periods that ended very badly indeed”. Have you spotted a theme yet? 

Let’s be clear – here on The Value Perspective, we have the greatest respect for Edwards and we certainly share his view that investors now need to be approaching the S&P 500 with a significant degree of caution. We just think that, if he really wants to make people nervous about US equities, there are better ways of doing so. 

Edwards’s two statistics may well resonate with people on a psychological level but what do they offer in practical terms? Taking his latter number, OK, so it is now more than 800 days since the S&P 500 last saw a 10% correction, but what does that actually tell us when there is still the best part of three years to go before we reach the longest-ever such period – 1,800 days? Or indeed why should we be more concerned by the market rising by 1 point for 1000 days, than by it rising by 100 points for 10 days? 

So what sort of information might prove of more use to investors? Well, as regular visitors to this site will be aware, we believe it is valuation that is the key determinant of whether or not you make long-term returns – not the amount of performance from a market’s trough, say, nor the length of time since its last correction. 

Valuation may be less interesting – to most people – than these stats and we must reluctantly accept it will generate less in the way of media coverage but it is a far more reliable yardstick. Before we explain just what it is telling us though, a brief caveat – valuation is of little use in the short term. Over the next year or so, anything could happen and valuation will not appear to offer any great insight. 

Over the longer term, however, it is a different matter – and indeed our natural inclination towards longer timeframes is one reason our preferred valuation metric is the cyclically adjusted price/earnings ratio – ‘CAPE’ for short – which encapsulates the average earnings generated by a market, adjusted for inflation, over the preceding 10 years. 

At the CAPE level, the US market now trades on a multiple of 27.8x. That ranks it in the 96th percentile of valuation – in other words, very expensive indeed. Still, we accept the CAPE is a more academic measure than some investors are comfortable with so, rather than go round the houses trying to persuade the doubters of its considerable merits, we will turn instead to the more commonly-used price/earnings (P/E) ratio.                                                                                                                                          

The S&P 500 is a market capitalisation-weighted index, which means movements in the share price of larger constituent companies will have a greater impact on the value of the index as a whole. Therefore, in order to avoid the skew that can come about by larger companies appearing cheap; we will use the value of the median stock within the market in our calculation. And if we do that? 

If we do that, the US market is as expensive as it has ever been since 1950, which is the earliest point for which this data is available. Put simply, on this measure, the average stock in the US market is even more expensive than it was in … 1999. If you still have that ominous roll of thunder to hand, now would be the time to use it. 

The genuinely scary aspect of this way of assessing the state of a market is that, unlike the number of days without a correction or the strength of a bull run, P/E ratios – and of course CAPE ratios – drive causation of subsequent market performance. Furthermore, if US equities did suffer a 10% correction, and one of Edwards’s arguments goes away, the market’s valuation would remain expensive.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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