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Consultant with extensive experience in finance and investment. Provides weekly analysis, which strives to unearth contrarian economic and finance ideas through an all-encompassing examination of the available information. Writings in the public domain are widely recognised as having foretold... More
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Charlie Fell
  • Bubble Trouble
    U.S. stock prices continued their upward march in January and have now jumped almost 25 per cent since the Chairman of the Federal Reserve, Ben Bernanke, first hinted last autumn that the central bank intended to introduce a further round of quantitative easing.  The Fed’s deliberate attempt to drive stock prices higher and generate second-round effects on economic activity has seen valuation multiples rise to nosebleed levels once again and it is becoming increasingly clear that another dangerous asset bubble may well be in progress.  Could investors really be foolish enough to push stock prices back into bubble territory for the third time in little more than a decade?  Unfortunately, the evidence from experimental economics suggests as much.

    Professor Vernon Smith, the joint-recipient of the 2002 Nobel Prize in Economics, is a pioneer of experimental economics and has conducted numerous controlled experiments to explore the dynamics of asset markets.  In a ground-breaking paper co-authored by Smith and published in 1988, the authors construct an experimental asset market in which the participants trade a fictional asset with a finite life of 15 periods.  Each subject is endowed with cash and shares of the asset, and is free to post bid and ask prices to buy and sell shares at will. 

    Each share of the fictional asset pays a random dividend at the end of each trading period and the asset’s terminal value following the last dividend payment is zero.  The subjects are instructed that there are four equally probable dividend outcomes at the end of each period and are given the payouts – (0, 8, 28 and 60 cents) that correspond to each outcome.  Determining the security’s fundamental value is a relatively simple task given the information provided.  The expected dividend payout in each period is 24 cents and the security’s fundamental value at the start of the 15-period trading experiment is therefore $3.60 – (15 x $0.24) and declines by 24 cents each period.

    Since traders in the experimental asset market have all the information necessary to calculate the asset’s intrinsic value, commonsense would suggest that formation of a bubble is virtually impossible, yet this is exactly what happens.  The inexperienced traders initially price the asset at a discount of as much as 80 per cent to its fundamental value, though the asset becomes overpriced by the fifth period and a massive bubble is created by the tenth period with the asset often reaching three to four times its fundamental value and sometimes, the price even exceeds the maximum possible value the asset could return in dividends – the case where the highest dividend of 60 cents is paid at the end of each trading period. 

    Needless to say, the asset’s price collapses towards zero as the experiment enters its final stages.  The substantial deviation of transaction prices from fundamental value alongside the large turnover of shares, which often amounts to as much as six times the outstanding stock of shares over the 15-period experiment, runs contrary to the predictions of economic theory.  The surprising result is often explained by the speculative motive whereby rational traders judge the behaviour of other participants to be irrational, and knowingly purchase overpriced assets with the hope of offloading them to irrational subjects at a higher price – the so-called ‘Greater Fools.’ 

    Thus, the presence of irrational traders is not necessary to produce a bubble so long as some traders believe others’ behaviour to be irrational.  However, this conclusion is undermined by recent work conducted by Vivian Lee and others, which controls for the speculative motive and limit the role of each subject “to that of either buyer or seller, completely eliminating the ability of any agent to buy for the purpose of resale.”  Prices still deviate substantially from fundamental value on heavy trading volume, and the pattern of prices exhibit the same boom-and-bust features originally reported by Smith.  It seems inexperienced traders behave irrationally after all.

    Professor Smith reveals that the only way to reliably eliminate price bubbles in experimental asset markets is through increased experience in the same environment.  Smith invites the original subjects to return for a second experiment with the same parameters as before, and contrary to what might be expected, a further bubble develops, though its duration and magnitude are less than observed in the first experiment.  The bubble gathers momentum far more quickly than in the first experiment with prices typically moving above fundamental value in the second period and reaches its climax by the seventh period with the security peaking at roughly twice its fundamental value.  Importantly however, upon returning for a third experiment, “trading departs little from fundamental value.”

    The evidence from experimental markets would appear to suggest that a third bubble is virtually impossible to produce, but in a 2008 paper entitled, “Thar she Blows׃ Can Bubbles Be Rekindled With Experienced Subjects?”, which Smith co-authored with Reshmaan Hussam and David Porter, the authors demonstrate that it is possible to precipitate a further bubble under certain circumstances. 

    The experiment is constructed in a similar manner to the previous two, but for an increase in both the variability of dividend payoffs and initial cash levels.  There are now five equally probable dividend outcomes at the end of each period – (0, 1, 8, 28 and 98 cents); the amount of stock distributed to subjects is halved and their initial cash level is doubled.  The greater liquidity combined with the increased variability of payoffs results in a third bubble that peaks in the fourth period, earlier than the first two experiments, and at a 75 per cent premium to intrinsic value.

    The conditions in today’s market environment would appear to resemble Smith’s third experimental market as the variability of outcomes following the “Great Recession” remains wide, while near zero interest rates combined with quantitative easing has allowed stock prices to trade at above-average valuations once again.

    The evidence from experimental asset markets suggests the Federal Reserve has given birth to another bubble in stock prices.  Investors should partake in the central bank's deliberate attempt to push asset prices higher and stay long the stock market for now.



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Feb 04 4:16 AM | Link | Comment!
  • The Truth about Stock Market Returns

    Too many investors focus on the daily noise emanating from financial markets, and all too often, fail to spot the primary trend.  Investors behave as if their time horizon is no more than one year, even though the noise overwhelms the signal over short periods.  Furthermore, stocks are a claim on a long-term stream of future cash flows that will be distributed to shareholders as dividends, or retained on their behalf and reinvested for future growth.  Their long-term nature should never be ignored. 

    It is only over long periods of a decade or more that investors can expect to realise the fundamental return implied by the sum of the dividend yield and expected future earnings growth; anything less and fundamentals are overwhelmed by the underling trend in valuation multiples.  Given the dismal returns generated by stocks over the past decade, it is reasonable for investors to ask whether a period of above-average returns lies in store.

    Before looking forward, it is important to appreciate the sources of return in the past.  U.S. stocks have delivered an average long-term nominal return of almost ten per cent since 1926.  Inflation has averaged 3 ¼ per cent a year over the period so the real return generated has been closer to 6 ½ per cent. 

    The income rate or dividend yield has provided almost two-thirds of the total real return; inflation-adjusted earnings growth has generated just one percentage point in return with the remaining 1 ¼ per cent stemming from an increase in the multiple that investors are willing to pay for a dollar of earnings from 10 at the beginning of 1926 to 25 at the end of 2009.  Thus, the real return implied by the fundamentals was roughly 5 per cent, but investors received an unexpected boost from the upward movement in valuation multiples.

    So much for the past, what real return can investors reasonably expect to earn in the future?  The first component of return, the dividend yield, is just 2 per cent today or roughly half the historical average.  Some will undoubtedly argue that the income yield is underestimated because of the corporate sector’s preference to retain flexibility with regard to payout policy and increasingly distribute cash to shareholders via stock repurchases.

    No adjustment is necessary however, if returns are forecast on a per-share basis because the impact of share repurchases is already reflected in the S&P 500’s per-share numbers.  Simply put, an investor can either participate in the buyback and forego the earnings-per-share accretion, or benefit from the share reduction and sacrifice the cash distribution.  It is simply incorrect to assume that a shareholder can have both.

    The second component of return, real earnings growth, is linked to the economy’s long-term growth rate.  Indeed, the growth rate of corporate profits has been virtually identical to GDP growth over long periods; both have increased at a real rate of roughly three per cent per annum since 1926.  However, current investors do not have a claim on economy-wide corporate profits, which includes all U.S. businesses; they have a claim on publicly-quoted per-share earnings.

    S&P 500 per-share earnings have grown at only a fraction of the economy’s growth rate over long periods.  Indeed, this component of return has contributed just one percentage point to over the past eight decades, though the rate of increase has been closer to two per cent over the past half-century.  The dilution can be explained by the capitalisation of new business enterprises with equity and the net new share growth has approximated population growth through time.  This would appear to be a logical outcome since the price per share cannot grow at a more rapid pace than wages per capita in the long run, otherwise shares would simply become unaffordable.

    It will undoubtedly be argued that the current low payout ratio below 30 per cent should equate to higher future growth, as a greater proportion of earnings is retained and reinvested in the business.  However, the historical data reveals that low payout ratios have typically resulted in lower future growth, as the corporate sector has displayed an extraordinary capacity to invest surplus cash in value-destroying ventures.  Furthermore, the increasing tendency to engage in share repurchases rather than increase dividends is already reflected in the per-share data and there is no evidence that this has accelerated trend earnings growth.  Thus, a two per cent number for future real earnings growth would appear to be a reasonable estimate.

    The final component of return, valuation change, is the most volatile and has acted as either a boost to or a drag on returns through secular bull and bear markets respectively.  The price multiple that investors were willing to pay for a dollar of trend earnings dropped from a peak of 31 in 1929 to a trough of 7 in 1949, it subsequently expanded to a peak of 25 in 1966, only to fall to 7 once again in 1982.  The 18-year bull market that followed saw the multiple jump to an unprecedented 40 in 2000, and despite a decade of poor performance, price multiple stands at a still-lofty 17.  It would be unreasonable to project an expansion in the multiple for the decade ahead, and a return to previous secular troughs in the years ahead is far more likely.

    Careful analysis of the sources of stock market returns suggest that investors can look forward to annual real returns of just 4 per cent in the decade ahead; the outcome could potentially be even more disappointing should history repeat.  The stock market is still not appealing to far-sighted investors.



    The views expressed are expressions of opinion only and should not be construed as investment advice.

    © Copyright 2010 Sequoia Markets

    Disclosure: No Positions
    Sep 17 4:16 AM | Link | Comment!
  • The Death of Equities

    Prophets of doom look forward with trepidation to the day that begins 48 hours before Christmas in 2012.  The date represents the fateful day that the Mayan calendar reaches its conclusion; those who follow the writings of the Maya Indians, who once ruled over much of Central America, believe that geological catastrophe lies ahead.  Back in the decidedly more mundane world of finance, perhaps the Mayans foretold a resumption of the secular bear market in global equity markets that began more than a decade ago. 

    In a similar vein, Citigroup’s investment division published a report last Friday that called time on the ‘cult of equity’; a tad tardy one might argue, but better late than never.  Strategists at the financial conglomerate trace the birth of the ‘cult of equity’ to the late-1950s, when inflation-adjusted stock prices finally eclipsed their 1929 peak and the investing public began to appreciate the merits of equity investment.  Fast forward to today and equity mutual funds are on course for the third consecutive year of negative cash flows, as the investing public continues to exit the stock market.

    The investment report captures the essence of the secular debate, but omits the twists and turns in the primary trend that have taken place over the past half-century.  This movie has screened before and the current secular downtrend is the second primary bear market since the late-1950s and the third of the past 80 years.  Just as before, the investing public has reacted with a considerable lag to a structural break in the primary trend; they typically return for a second beating after the first bear shock, albeit less enthusiastically than before, but twice bitten and thrice shy.

    It took investors a considerable period of time to erase painful memories of the ‘Great Depression,’ and only the 1950s – the best decade of stock market returns relative to Treasury bonds on record – managed to entice them back into the equity market.  The investing public poured monies into equity mutual funds through the go-go years of the 1960s; stocks became the investment vehicle of choice as enthusiasts hailed the arrival of a ‘new era’ and with it, the eradication of business cycles.

    The optimism proved misplaced and economic volatility returned as inflation spiralled out of control.  The investing public took the 1966 bear market in its stride, but a further year of negative returns in 1969 contributed to a surge in equity mutual fund redemptions and the industry suffered its first annual cash outflow in post-war history. 

    The exodus continued throughout the 1970s, and accelerated following the sharp decline in stock prices mid-decade.  Indeed, Business Week reported in the summer of 1979 that, “At least seven million shareholders have defected from the stock market since 1970.”  In the same year, the total net assets of money market mutual funds exceeded those of equity mutual funds, as the investing public’s appetite for risk simply disappeared.

    The secular bear market ended in the early-1980s, but it took almost a decade of strong returns before the investing public embraced equity investment again.  Equity fund sales soared during the 1990s, as talk of a ‘new era’ moved centre-stage, and even Alan Greenspan, the then-Federal Reserve Chairman, appeared to have bought into the brave new world.  Equity fund sales increased from less than $8 billion a month at the start of the 1990s to roughly $4 billion every business day by the decade’s end.

    A “buy on the dips” mentality became deeply ingrained in the investing public’s psyche; being out of the stock market was considered a more risky proposition than being in the stock market.  Three consecutive years of negative returns dented the belief that persistent double-digit returns are carved in stone, but following just one year of cash outflows, equity fund sales picked-up once again.  However, a further collapse in stock prices has left deep scars, and bullish optimism that the investing public would channel their high liquidity balances into equity funds has by now been dashed.

    Individual investors were duped into believing more than a decade ago that stocks were the safest asset for long-term investors, but the negative return generated by stocks over the past decade has revealed that the long-run may simply be too long.  The same arguments were espoused at the height of the secular bull markets of the 1920s and 1960s, but careful examination of the subsequent data reveals that equity investment is not a guaranteed route to wealth generation.

    Consider that an investment in the U.S. stock market at the end of 1928 did not breakeven in inflation-adjusted terms until 1944, or that equity purchases made at the end of 1968 remained underwater in real terms until 1983.  However, the investing public does not accumulate stocks simply to maintain purchasing power and realising the average historical return is likely to be the minimum objective.  It took the 1928 investor almost seven decades to attain that goal, and following the disappointing market performance in recent years, the 1968 investor is still waiting. 

    The words of John Maynard Keynes seem apt; “In the long run, we’re all dead.”

    Secular bear markets are painful events and the evidence reveals that an investing public twice bitten is thrice shy.  The ‘cult of equity’ is dead.



    The views expressed are expressions of opinion only and should not be construed as investment advice.

    © Copyright 2010 Sequoia Markets

    Disclosure: No Positions

    Disclosure: No Positions
    Sep 10 6:15 AM | Link | Comment!
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