Equity risks must be judged according to right model

SERIOUS MONEY:US STOCK prices have side-stepped the seasonal chill and continued their upward march through November to reach new recovery highs. The turnaround in the market's fortunes was driven initially by Ben Bernanke's remarks in late August that a further round of quantitative easing was in the pipeline.

The upward trajectory in equity values was subsequently reinforced by economic data that came in at the higher end of expectations and erased fears of a double-dip recession.

The positive economic momentum combined with Bernanke’s determination to push asset prices higher has sparked renewed enthusiasm for risk assets. Even the mighty Goldman Sachs has dismissed its previous caution in favour of a more bullish slant.

Alan Greenspan declared on CNBC last Friday that the risk premium on stocks is at the highest level in five decades. Momentum [the primary driver of short-term performance] clearly sides with the bulls for now, but the notion that valuations [the key determinant of long-term returns] are at the most attractive level in generations is simply bunkum.

The valuation of common stocks is the cornerstone of successful investment for long-term investors of every variety. However, the output arising from a sensible valuation exercise often proves controversial, and is frequently ignored to the detriment of long-term performance.

The decision prescribed by valuation models, either to reduce or increase weightings, is typically avoided because investment managers are rewarded on the basis of annual performance. Asset allocation decisions are typically taken monthly, decisions that are often swayed by momentum, by the mood of the market.

Tactical considerations aside, a properly-constructed valuation model should be used to provide an anchor for fair value, and to shed light on the risks that are being borne via current allocations.

The price/earnings multiple is the most widely employed valuation tool, though the output is typically invalidated by the use of single-point, forward-looking projections of operating profits. It is not sensible to use such single-point estimates when profit margins are close to record highs, and the resulting projections bear little relation to the stock market’s long-term earnings power.

Furthermore, the standard analysis typically employs earnings numbers that are calculated before exceptional and extraordinary items. Valuation analysis conducted in this manner is flawed since such losses are a normal consequence of the business cycle and are borne directly by shareholders.

The use of operating earnings overstates corporate profitability through the business cycle. Supposedly once-off charges have averaged circa 15 per cent of operating earnings over the past two decades. They fall as a share of operating profits as the economy expands and a rising tide lifts all boats, but the share increases as the expansion slows and exposes poor capital investment decisions.

The average annual write-off equates to roughly one to two cents for every dollar of capital invested, which would appear to be a pretty standard failure rate for a vibrant capitalist economy.

In this context, it is pretty clear that exceptional and extraordinary items matter and must be included if the valuation analysis is to have any validity at all.

The use of relatively simple regression techniques suggests the US stock market’s long-term earnings power is currently $65 per share. The resulting price/earnings multiple is close to 19 times, a level that in the past has been followed by annualised 10 returns of just 4 to 5 per cent.

Ten-year treasury bonds are currently yielding 3 per cent, which, once subtracted from the 4-5 per cent long-term return estimate for stocks, leaves an equity risk premium of just one to two percentage points.

Contrary to Greenspan’s assertions, the risk premium on stocks is nowhere near the highest levels registered in post-war history. In fact, the relative attractiveness of stocks versus treasury bonds has rarely been less appealing, though it should come as little surprise that the serial bubble blower himself was at the helm of the Federal Reserve during two of the previous episodes – the 1990s technology bubble and the subsequent echo bubble that began in 2002.

The current risk premium is more than 10 percentage points below the post-war record of the late-1940s and is three to four percentage points shy of the historical average that prevailed prior to the bubble episodes over which Greenspan presided.

Greenspan failed to detect a bubble in the stock market in the late-1990s even though Treasury Inflation-Protected Securities offered higher prospective long-term returns than equities. His latest musings on equity valuations should be considered in this light and dismissed as nonsense.

Short-term momentum is clearly positive at this juncture, but the notion valuation provides a further pillar of support to the cyclical bull market is simply not supported by the facts. Stocks are far from cheap. In fact, they’ve rarely been more expensive.

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