Pavlov’s dog, named after Russian scientist Ivan Pavlov (1849-1936), was conditioned to salivate when it heard a bell ring. It came to anticipate food just from the noise, even when it could see none. Investors in modern markets are like Pavlov’s dog. They hear about money printing and are conditioned to bid up prices. Disappointment is likely to follow.
This is a phenomenon present in most developed country stock and bond markets, including the USA, eurozone and Japan. It also affects both stocks (shares) and bonds. But I’ll concentrate on US stocks to illustrate.
US stocks look pretty expensive, bid up on a wave of quantitative easing (money printing). But the underlying fundamentals for US stocks are poor, when starting from current price levels in the face of weak earnings growth.
…investors have been conditioned to bid up prices when they think more money printing is on the way…
Yet investors have been conditioned to bid up prices when they think more money printing is on the way. Ben Bernanke at the Federal Reserve just has to ring the bell to get the printing presses rolling and investors start salivating.
The P/E ratio of the S&P 500, the main US stock index, is 17.4. This is above the long run average of closer to 16. The dividend yield is nothing to write home about either, at just 2.4%.
Ah, but US companies also pay out a lot of cash using stock buybacks, I hear you say. This is where companies use cash to buy shares in the market and cancel them. Earnings are then split across fewer remaining shares, causing earnings per share (EPS) to rise, which also drives up the share price.
Well that’s true. In fact buybacks have been running at record levels. In 2012 they amounted to $400 billion a year. The current market capitalisation (total market value at current prices) of the S&P 500 index is $14,728 billion ($14.7 trillion).
Signs so far are that the amount of buybacks in 2013 could even be higher than the 2012…
So if the absolute amount of buybacks in 2012 stays at the same level during 2013 that’s 2.7% of market value that will be paid back to shareholders. Add the dividend yield of 2.4% and total shareholder cash yield would be 5.1%. Signs so far are that the amount of buybacks in 2013 could even be higher than the 2012 figure, but let’s assume they stay the same.
Lots of cash is going to shareholders then. Sounds pretty good right? Not so fast – there’s a catch.
The trouble is 5.1% shareholder cash yield is a huge chunk of current earnings. Earnings yield is EPS divided by share price, which is the same as the inverse of the P/E ratio (1 divided by P/E = E/P = earnings yield). So if the P/E is 17.4 then the earnings yield is 5.7%. That’s how much profit per share the S&P 500 companies are making on average as a percentage of their share prices.
If total shareholder cash yield (dividends plus buybacks) is 5.1% and earnings yield is 5.7% this means over 89% of earnings are being paid out to shareholders (5.1% divided by 5.7% equals 89%).
Put another way, only 11% of earnings are being retained within the S&P companies. Retained profits are needed to renew old equipment and to invest in future growth. With such a low rate of reinvestment it’s no surprise that EPS isn’t growing, on average.
So what does that 17.4 P/E for the S&P 500 mean? It can be one of two things.
First, investors could still expect strong earnings growth in future, despite the evidence to the contrary. Given the ongoing weakness in the US and global economy this seems an unlikely outcome in the near future. Roughly half of S&P 500 revenues come from overseas, including the troubled eurozone. And as I’ve shown, companies are not investing in growth.
Second, investors are pricing the market at a high level on the basis that they will accept much lower returns in the future than than they have in the past. I doubt that this is what they want, although many may have resigned themselves to this outcome.
…central bankers – the “Pavlovs” – are obsessed with money printing…
If inflation stays ultra low for the next decade then maybe it even makes some sense to accept lower nominal (pre-inflation) returns. But permanently low inflation seems unlikely in a world where central bankers – the “Pavlovs” – are obsessed with money printing (quantitative easing). We have an on/off race to the bottom between fiat currencies, and persistent price inflation is the likely outcome.
At OfWealth we expect earnings growth in the US, and other developed markets, to remain weak for many years to come. This means current prices of developed market stocks are too high for our taste.
We also don’t want to accept low future returns from our investments by overpaying now for low growth in the future. And we don’t have to, because there is a better way of investing.
That is to pay low prices for all investments, which is called value investing. In short this means being highly selective and looking for things that are out of favour with the investing pack of hounds. It sometimes means having to wait a long time for the right opportunities to come along.
So we encourage you, our fellow OfWealthers, to leave US stocks (and bonds) for the dogs. They’re all barking up the wrong tree.
Until next time OfWealthers,