Why we need to focus on earnings expectations
Ever since Paul Volcker, the US Federal Reserve Chairman, tamed the inflation genie in the early 1980s we have seen the US ten-year bond yield decline from 15.84 per cent to the current record low of 0.54 per cent.
Correspondingly, the share market boom has only been interrupted by four significant shocks, being the 1987 crash, the 1990-1992 “recession we had to have”, the 2000-2002 dot.com bomb and the 2007-2009 Global Financial Crisis. On each of these four occasions, the share market typically declined by around 50 per cent.
Due to the psychology of greed and fear, it is virtually impossible for humans to buy into significant bear markets. Many investors feel anxious and they would rather be a net seller, often during the depths of a bear market. For those with composure this generally creates an opportunity. For example, from its trough during the Global Financial Crisis in March 2009, the S&P 500 has rallied five-fold from 700 points to a record peak of nearly 3,400 points last month. That is an ungeared average annual capital return exceeding 15 per cent over eleven years. And that excludes the accumulation of dividends.
Many investors today are quite rightly focussing on the very recent and dramatic 19 per cent decline of the S&P 500 to the current 2,750 points, and the similar sharp decline experienced by most Western World share markets over recent weeks. Many investors are also focusing on the record low bond yields which ordinarily imply a very weak economy, very low inflationary expectations and pressure on corporate earnings. And many investors are focusing on data released around the Coronavirus, in an attempt to get an edge as to whether the current weakness is likely to be relatively short-lived, or not.
While investors will feel secure in the thesis that record low interest rates should underpin high valuations, it is important to point out there are periods in recent economic history when the movement in inflation, interest rates and PE multiples have risen simultaneously and fallen simultaneously. While it may seem counter-intuitive, there have been periods when the correlation between the movement in bond yields and PE multiples have been positive (1).
I believe the missing piece of the jigsaw puzzle to this conundrum is earnings expectations, and to that end both Montgomery and Montaka Global Investments will continue to focus on high quality stocks with good prospects.
(1). If equities are a claim on real assets and bonds are a claim on a stream of coupon payments that is fixed in nominal terms, then our obsession with yield ratios (earnings yields versus bond yields, where earnings yields are the inverse of PE ratios), without grasping earnings expectations, may prove deficient. For example, during the two decades to 1968, US inflation was rising, and there was a positive correlation between rising bond yields and rising PE multiples. In that twenty year period, US bond yields jumped from 1.4 per cent to 6.2 per cent (average of 3.2 per cent), PE multiples (the inverse of Earnings yields) jumped from 6X to over 16X (averaged nearly 12X) and Dividend yields declined from 8.5 per cent to 3.7 per cent (average of 4.6 per cent).