Macro-economy

Posted on by Devesh Deepak Asset Allocation, Equity, Investment, Macro-economy, Personal Finance, Prudent Investment, Sensex, Valuation

Valuation: Cyclically adjusted PE Ratio

P/E Ratio is one of the simplest valuation multiples and that is also its main shortcoming. The ratio of current price to recent last four quarters earnings is a simple but very effective tool to evaluate a stock, portfolio or market since the beginning of the stock market. The lower the PE, the less you are paying for future earnings. It’s quick and easy, hence popular. The criticism for P/E ratio is that it doesn’t account for the cyclical nature of a business or the different phases of the business cycle. Thus, P/E ratio can’t be extrapolated as price and earning of one era can’t be compared with price and earning of a different era.

The famous value investors Benjamin Graham and David Dodd, in the early 1930s in the book Security Analysis, argued that a single year’s earnings would be too volatile to evaluate a company’s real value in the marketplace. To control for cyclical effects, Graham and Dodd recommended dividing price by a multi-year average of earnings and suggested periods of five, seven or ten years. Based on that idea, Robert J. Shiller and John Y. Campbell in 1998 developed a cyclically adjusted price-to-earnings ratio (CAPE), which puts the current market price in relation to the average inflation-adjusted profits of the previous 10 years. The purpose of the 10-year observation period is to ensure that the profits are averaged over more than one earnings cycle. Shiller and Campbell’s research found a negative correlation between the CAPE ratio and the stock market performance over the next ten years. A high current CAPE ratio meant poor future stock returns.

cape

The cyclically-adjusted price-to-earnings (CAPE) ratio of a stock market is one of the standard metrics used to evaluate whether a market is overvalued, undervalued, or fairly-valued. This metric was popularized during the Dotcom Bubble when Robert Shiller, a Yale University Professor of Economics and Noble Prize winner, correctly argued that equities were highly overvalued.  For that reason, it’s also referred to as the “Shiller PE”, meaning the Shiller variant of the typical price-to-earnings (P/E) ratio of stock.

Does the Shiller PE predict the future returns? In his book “Irrational Exuberance,” Shiller shows that CAPE is correlated to the subsequent 20-year annualized return after inflation. A low P/E bodes well for the next 20 years of investing, whereas a higher ‘PE 10’ suggests a lower expected return.

The GuruFocus.com has a nice article on Shiller PE – A Better Measurement of Market Valuation in which they write:

If we assume that over the long term, the Shiller PE of the market will reverse to its historical mean of $mean, the future market return will come from three parts:

  1. Contraction or expansion of the Schiller P/E to the historical mean
  2. Dividends
  3. Business growth

The investment return is thus equal to:

cape1

cape2

We don’t have much Sensex data prior to 1990 hence can’t compare our finding with the US data. Still, the above graph shows a remarkable correlation close to 80% between implied return and the actual 3 years return. For calculation, the business growth is taken as average annual GDP growth since 2000. We believe the real earning growth of composite or large-cap index tends to align with GDP growth over long-term.

Despite its value in projecting future returns over long periods of time, the Shiller PE is often misused when applied to any periods other than long ones. The elevated Shiller PE is in no way an indication that investors should sell their equities. In reality, the Shiller PE has almost no predictive value in determining where the market will go in the next year or other shorter term periods. We must emphasize the fact that valuation metrics are not a market timing tools.

In terms of shortcomings, Shiller PE is based on the false premise that earnings can be normalized using inflation only. Population growth, productivity growth, interest rates, and dividend payout ratios are all key ingredients in earnings growth and they are neglected by this ratio.

No valuation ratio is ever going to explain the market fullest. Every multiple has some positives and some negatives but the Cyclically Adjusted Price-to-Earnings ratio or “CAPE” has shown remarkable ability at least in the US market for assessing long-term future returns. However there are situations when the earnings growth is higher for reasons other than inflation, Shiller PE may give a false reading, and it will show much higher value than the reality.

Posted on by Devesh Deepak Bonds, Investment, Macro-economy, Yield Curve

Yield Curve Primer

A yield curve is a graphical representation of the current interest rates. The interest rate varies across the maturity.  The yield curve shows the rate of return that can be locked in now for various terms into the future. The left, vertical Y-axis of the graph shows the YTM that is currently available in the marketplace. The bottom, horizontal X-axis shows the G-Sec maturity. The yield curve is the line connecting YTM across maturities and looks something like this:

YTM000

A yield curve can be created for any specific segment of the bond market, from AAA-rated corporate bonds to single-B rated corporate bonds. The G-sec yield curve is the most widely used because G-Sec has no perceived credit risk, which would influence yield levels, and G-sec and T-bill market includes securities of every maturity, from 3 months to 40 years.

As the investor in the Bond, we all know that Yield to maturity reflects the total return an investor receives by holding the bond until it matures. But why the yield curve is important and does it has a predictable power?

The information contains in the yield curve is valuable for the prediction of business cycles, inflation, and monetary policy; the response of the yield curve helps to understand the extent of transmission of monetary policy and, it is also the barometer to measure the impact of any surprises on the macro economy. The importance of Yield curve can also be gauged by the fact that it represents the relationship among short, medium and long-term yield and most of the pricing activity taking place in the bond markets centres around it. The Yield curve is also called Term Structure of Interest Rates. To understand the shape of the yield curve, we must understand the variables of yield curve – level, slope, and curvature.

Level = Average yield of Short Term (3mnths), Medium Term (2years) and Long Term (10years).

Slope = Spread = Difference in the yield of Short Term (3mnths) and Long Term (10years).

Curvature = [2 x Long Term yield (10years) – Short Term yield (3mnths) – Medium Term yield (2years)].

And examine the theories and hypotheses that explain the yield curve and the relationship of short, medium and long-term interest rates:

  • Pure expectations: long-term rate is the sum of current rate and future expected short-term rates, adjusted for risk.
  • Liquidity premium: long-term rate is the sum of current rate and future expected short-term rates, adjusted for risk, plus a premium for holding long-term bonds, called the term premium or the liquidity premium.
  • Preferred habitat: In addition to pure expectations and liquidity premiums, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their “preferred” maturity, or habitat.
  • Market Segmentation: postulates that the yield curve is determined by supply and demand for debt instruments of different maturities.

The Yield curve has five major characteristics:

  • The change in yields of different term bonds tends to move in the same direction.
  • The yields on short-term bonds are more volatile than long-term bonds.
  • The Long-term yields follow the short-term yields.
  • The yields on long-term bonds tend to be higher than short-term bonds.
  • At a given level, yields are mean reverting.

The pure expectations hypothesis explains the first three characteristics; the liquidity premium theory explains the fourth characteristic and the market segmentation explains the last one.

The Shape of the Yield Curve

There is a dynamic relationship between fiscal and monetary developments – government debt and the budget deficit, real output, inflation and the monetary policy rate– and the shape of the yield curves.

Normal Curve

A normal, upward-sloping yield curve suggests the economy will grow in the future, and this may lead to higher inflation and higher interest rates. No one will buy longer-term securities without a higher interest rate than those offered by shorter-term securities. A normal yield reflects the easing of monetary policy and easy liquidity. And the economy expected to expand. The upward sloping normal yield curve is the most common shape of the yield curve.

YTM002

Inverted Curve

When the long-term yields fall below short-term yields, the yield curve becomes inverted. An inverted yield curve indicates the economy is to slow or decline in the future and this slower growth may lead to lower inflation and lower interest rates across all maturities. An inverted yield curve typically indicates that central banks are ‘tightening’ monetary policy, limiting the supply of money in the banking system and thus control credit availability. An inverted yield curve has indicated, in the past, the slowing down of economic growth and even recession.

YTM001

Flat Curve

When the short-term bond yields increases and yields on long-term bonds decrease, the yield curve flattens or appears less steep. A flattening yield curve can indicate that expectations for future inflation are falling and thus the demand higher long-term bonds fall. Since inflation is less of a concern, the long-term premium shrinks. A flat yield curve indicates a slower economic growth.

YTM004

Humped Curve

A humped yield curve is a kind of flat yield curve or reflects uncertainty about specific economic policies or conditions, or it may reflect a transition of the yield curve from a normal to inverted or vice versa.

YTM003