B.ILLY CONNOLLYThe great Scottish comedian, who recently retired from the show, had a joke about two men filming a lion for a wildlife documentary. The lion suddenly looks up. The men fear they have been discovered. One of them slowly takes off his boots and puts on a pair of running shoes. “You will never overtake a lion in these,” says his colleague. “I don’t have to escape the lion,” replies the first man as he slowly ties his shoelaces. “I just have to overtake you.”
The joke pretty much captures a certain approach to investing. What matters is not so much whether you can achieve an absolute target for returns. What matters is whether the asset you are investing in significantly outperforms the alternatives.
Stock prices in America are at an all-time high. The cyclically adjusted price-earnings ratio (CAPE) ratio, a measure of value popularized by Robert Shiller of Yale University, was only two times higher than it is today – in the late 1920s and early 2000s. However, a recent study by Mr Shiller, Laurence Black, and Farouk Jivraj suggests that today’s high stock prices may still be justified given such low interest rates. Compared to real returns on risk-free government bonds, stock prices are indeed very attractive. Stocks don’t have to outperform their historical returns to be worth holding. You just have to leave bonds behind you by a decent margin.
A key aspect of this thinking is that earnings yield – the inverse of the price-earnings ratio – is a decent forecast of expected stock returns. An empirical study by Shiller and John Campbell in 1988 found that stock returns help predict long-term returns. The dividend yield (ie the ratio of dividend to price) and three different measures of income yield are all predictive, meaning they explain at least some of the fluctuations in future returns. The longer the horizon over which the returns are measured, the better the forecast. And the best measure is an average earnings of a few years, as the profits are loud from one year to the next. Using an average of recent earnings goes back at least to Benjamin Graham, a stock valuation pioneer. Mr. Shillers CAPE is simply an extension of this approach.
The intuition behind the predictive relationship is simple. When stock prices are high relative to a measure of fundamental value such as earnings, subsequent returns tend to be low, and vice versa. A low income return means that at this point in time investors are willing to accept only low returns in the future. If you find this trivial, consider the following. Low returns could be a forecast for corporate earnings instead. But they are not. This analysis of returns, projections and returns applies to assets other than stocks, according to Discount Rates (2011), a panoramic survey by John Cochrane of the Booth School of Business at the University of Chicago. High real estate prices in relation to rents indicate low returns, not rising rents. Credit spreads on bonds are a signal of returns, not the probability of default.
If all else is equal, the lower the income return the less interested you should be in holding stocks (or holding fewer stocks). But not everything else is the same. The price of the asset should reflect the expected cash flows, which will be discounted over the life of the asset. The return on income gives you the “expected” part of this equation; The real bond yields cover the “discounted” part. The gap between the two is a forward-looking measure of the equity risk premium, the excess return on holding stocks.
The graphic shows a rough measure of this risk premium. It varies over time in large part because risk appetite varies over time. Although it was higher in the past, it is not obviously low now. In the 1990s, during the dot-com boom, the premium for owning stocks was negative – real interest rates were a whopping 4%. Now real interest rates are negative. It’s not difficult to beat this type of yield. Mr. Shiller and his colleagues apply a similar measure based on CAPE Return and expand them to equity markets other than the Americas. Their conclusion is that despite their high prices, stocks are reasonably priced compared to bonds – even in America, but especially in the UK, the rest of Europe, and Japan.
An increase in real long-term interest rates worldwide would disrupt the entire constellation of high asset prices. It is hard to believe that this is imminent. In an ideal world for investors, the expected returns on all assets would be better. But we are where we are. If you can’t escape the lion, maybe all you can do is try to escape the other.
This article appeared in the Finance & Economics section of the print edition under the heading “The Lion Sleeps Tonight”.