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The Shiller Equilibrium: What Is The Relationship Between Growth And P/E Ratios?
Fri, Dec. 12 • 12 Comments
- According to Robert Shiller, the market should maintain a constant ratio between earnings growth and the earnings yield; failure to do so results in booms and busts.
- We ask whether that equilibrium really exists and, if it does, whether or not it must remain at a constant level across time.
- An historical comparison of the history of the relationship between earnings growth and the earnings yield suggests that if an equilibrium exists, it appears to vary across time.
- If the Shiller equilibrium varies, this may explain why the P/E10 has been able to remain so high for so long.
Emerging Markets Are In Trouble
- Commodity prices and the dollar suggest emerging markets will suffer, especially relative to developed markets.
- The downturns in oil, nickel, silver, and gold are all particularly ominous.
- China may be the next domino in the emerging market crisis to fall.
Does Gold Disprove Marginal Utility?
- Looking on from Mars or from Omaha, it would seem that a vital commodity like water would be infinitely more valuable than a non-essential commodity like diamonds.
- The classical labor theory of value and the now-standard neoclassical theory of marginal utility attempt to explain why non-essential commodities are typically more expensive than essential ones pound for pound.
- The value of world gold supplies as determined by market prices tends to match or exceed the value of most other primary commodities, which suggests that utility plays no role.
- If marginal utility were a sufficient account of prices, it could explain both the difference in unit prices and the parity of aggregate prices for gold and other commodities.
- If prices are determined by simple supply and demand, then the size of the gold market suggests that humans collectively have a higher demand for gold than for essential goods.
Big Macs, Catch Up, And The Dollar Index: Thoughts On The Future Of Global Growth (Part II)
- The richer a country is, the more likely its nominal exchange rate is correlated with its real exchange rate.
- According to the "Penn Effect," the absolute level of a country's real exchange rate is virtually an inverse function of real per capita GDP.
- Exceptionally high real exchange rates among rich economies seem to be linked historically with exceptional GDP growth in poor countries over both the long and short terms.
- Miraculous growth in emerging markets and the rise of the Penn Effect appear to be contingent on American dominance of the global economy.
- Were another country to displace America in its hegemonic role, long-term growth rates among the catch-up countries might collapse.
Big Macs, Catch Up, And The Dollar Index: Thoughts On The Future Of Global Growth (Part I)
- The global economy is well into its third emerging markets crisis since the end of Bretton Woods, but there has been no panic yet.
- Historically, investing in the global growth story has been very risky over both the short and long term.
- The best time to risk exposure to emerging markets may be after significant appreciation in the dollar against rich-world currencies.
- Previous emerging market panics seem to have been triggered by Fed tightening.
- In light of weak global growth and commodity prices in this cycle, tightening by the Fed in the coming months may trigger the panic that has been missing so far.
Water And Diamonds, Iron And Gold: The Problem With Commodity Prices
- Why do basic commodities (water and iron) and precious commodities (diamonds and gold) cost the same?
- Changes in yields, especially the earnings yield, have historically been linked to changes in aggregated commodity prices but less so in individual commodity prices.
- Individual commodity prices and levels of production seem to adjust to aggregate changes in a systematic way.
- In recent decades, gold and silver prices appear to be inversely correlated with stocks but positively correlated with basic commodity production levels.
- Emerging markets, commodity prices (especially for expensive commodities), and basic commodity production levels appear to be due for another major collapse.
Blood And The Street: Do Foreign Policy Crises Matter?
- Investors often worry during geopolitical crises, and market commentators attempt to predict their outcomes.
- The history of American markets suggests that crises are typical during bull markets.
- Considering the inverse correlation between stocks and commodities over much of the last century, it is possible that crises are characteristic of stock market booms.
- If there is a time to worry, it is only after oil prices have spiked and when geopolitical crises take on a primarily anti-American tone.
- The current crop of crises do not appear to pose immediate threats to the market.
Playing Chicken With Bulls And Bears
- CAPE does a poor job of predicting bullish returns in the years before market tops.
- CAPE's failures to predict returns in these instances can be used to time the market instead.
- We may be nearing the end of this bull market, but it probably has a couple of years left in it.
Earnings Growth Suggests Things Will Get A Lot Better Before They Get Worse
- By looking at the shape of earnings growth over the course of a business cycle, we can make predictions about future stock performance.
- The history of earnings growth and the stock market indicates that medium-term returns are propelled by brief, reflexive, contrapuntal bursts in earnings.
- Earnings grew nearly 800% in the twelve months ending in June 2010 after collapsing over 80% from their June 2008 levels.
- If we can extrapolate from the history of earnings growth, we can estimate that the S&P 500 will roughly double by the end of the decade.
- History also suggests that the gains could be disproportionately skewed to the 2014-2017 period.
Stocks And Bonds Risk Going Parabolic
- There is an increasing likelihood that interest rates will decline significantly over the next two to three years.
- If rates decline, stocks are likely to move up with bonds.
- If falling long-term yields flatten the yield curve sufficiently, that could increase the risk of a market crash.
- In a low-yield, low inflation environment, however, those crashes tend to be preceded by periods of exceptional returns.
- This bull market will likely remain intact until inflation picks up.
CAPE Has A Deflation Problem And Earnings May Be The Solution
- CAPE appears to do a poor job of predicting returns (particularly to the upside) during periods of volatile earnings and deflationary pressure, such as in the late 1990s.
- Stock market performance appears to be positively correlated with earnings growth only during periods of volatile earnings and deflationary pressure; otherwise, it is negatively correlated.
- Earnings volatility appears to be heightened during periods of very low inflation and low yields.
- Insofar as we are in a period of volatile earnings and deflationary tendencies, CAPE will probably be an unreliable guide for the remainder of the decade.
- This is additional evidence that this market will likely post strong returns for the remainder of the decade, although there is always need for more research and analysis.
CAPE, Earnings Volatility And Stock Returns: 1871-2019
- Eliminating earnings volatility, as in Shiller's CAPE, reduces the P/E ratio to shadowing deviations from the long-term moving average of stock prices.
- Stocks behave contra-cyclically during bull markets, becoming inversely correlated with commodities, inflation, interest rates, and earnings, but in this article, we will consider earnings volatility itself, from a few perspectives.
- Medium-term (five- to ten- year) fluctuations in stock prices seem to be partially predicted by fluctuations in earnings volatility, although it is not especially clear how or why.
- Based on an extrapolation from the historical relationship between P/E, earnings, and stocks, it appears that a stock market boom will continue until the conclusion of the decade.
The Roaring Twenties Are Back
- This market has all the characteristics of a strong bull: weak commodities, a wide yield curve spread, disinflation, P/E expansion, and counter-cyclical stock behavior.
- This market and the crisis that preceded it is often compared to the Depression, but a far better comparison is the Roaring Twenties and the 1921 crisis.
- That leaves us with three difficult questions to answer: when will this bull market end, what will the aftermath look like (Depression? Stagflation?), and do we have any policy alternatives?
- The market will probably grow for a few more years, and the aftermath will probably be pretty grim, as our understanding of market forces has barely progressed since 1929.
Currencies, Inflation And Global Stock Indexes: Are Devaluations More Good Than Bad?
Wed, Mar. 26 • Comment!
- Currency strength and inflation do not predict long-term global stock index performances.
- Most countries' stock market indexes tend to negatively correlate with their exchange rates (i.e., positively correlate with currency strength) over the long run.
- But, those countries whose stock market indexes most strongly correlate with their exchange rates (negatively correlate with currency strength) clearly tend to outperform markets with strong currencies.
- This effect seems to be stronger among high-performing markets, but may hold among weaker performers, too.
- The central questions that remain are whether or not this is a necessary condition of global markets and how total return data would figure into this kind of analysis.
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