Research showing hope for stocks? Very questionable
Lance on Feb 24 2008 at 5:05 pm | Filed under: Asset Allocation, Domestic Equities, Risk, Valuation
Mark Hulbert reports on two indicators that historically have pointed towards above average returns for stocks:
The indicator in question focuses on corporate money-raising. Considerable research has shown that when companies turn aggressively to the equity market for their financing needs, through new issues or secondary offerings, it is a sign that the stock market is overvalued. Though there is no easy way to interpret the data, current trends in corporate finance appear no worse than neutral for the stock market’s intermediate-term prospects. And the data may actually be painting a bullish picture.
[...]
Professor Lamont, who is also a portfolio manager at DKR Capital, a hedge fund in Stamford, Conn., has calculated the new-list percentage back to 1929. Its all-time high was nearly 15 percent, at the beginning of the Depression. Its second-highest level, almost 11 percent, was in March 2000, just before the Internet bubble burst. (He published these results in 2002 in an academic working paper.)
This result doesn’t surprise me, and is intuitively reasonable. There is also this:
Two researchers who have studied these patterns are Malcolm P. Baker, a finance professor at Harvard Business School, and Jeffrey Wurgler, a finance professor at New York University. For each year from 1927 through 1996, the professors calculated the share of total capital raised by publicly traded corporations that came from issuing stock — what they call the equity share.
Over the 12 months after the quartile of years with the lowest equity shares (when this proportion was no higher than 14 percent) the stock market returned an average of 14 percent, according to the professors. In contrast, the market had an average net loss of 6 percent following the quartile of years with the highest equity shares (when this proportion was no lower than 27 percent). Their results were published in the October 2000 issue of the Journal of Finance.
This likewise makes sense that you would generally observe those conditions.
Where does the equity share stand now? In an e-mail message, Professor Wurgler said it was 6.1 percent for 2007 through September, the latest date for which data are available. Because this puts the current market solidly in the quartile of past years that were followed by above-average returns, he says the data are sending “a bullish stock market signal.”
So maybe I should be trading in my bearish hat over the next few years? I don’t think so:
In separate interviews, he and Professor Baker hastened to add that this bullish signal by no means justifies throwing caution to the wind. They pointed out that companies have had far easier access to cheap debt financing in recent years than they did in earlier decades. As a result, they argued, the current low equity share may not be strictly comparable with similarly low previous readings — and thus may not be as bullish as it otherwise would appear.
Throw in large cash reserves, record profit margins (which are reliably mean reverting) and companies hardly needed to issue equity. They already did that in extremes earlier. Much financial activity was diverted to private equity and M&A as well.
But judging from how companies have been raising new money, Professor Baker said, there was little evidence of extreme levels of speculation at the recent stock market high. At least to this extent, he said, this means that “there is less downside risk in the market today than there was in March 2000.”
Maybe so, though it seems a big risk one must account for in any decision on how to allocate assets. The problem, like with much finance theory, is that these are coincident indicators of the real problem, excessive speculation driving assets far above a reasonable estimate of their long term value. When stocks are overvalued companies do tend to issue equity, we see more companies going public, etc. However, they are not the actual driver of returns, and thus can give us a hint to check on whether the market is overvalued, but not whether it is.
Simply put, any reasonable assumption about growth in earnings, payout ratios and profit margins predicts low returns. Whether those low returns are fairly valued or not, there they are. If valuations decline to boot, we have a major decline in store.
I don’t believe investors realize how low the embedded returns in stocks are. Since I believe investors think that the US stock market can give them higher returns at these levels than is likely, when they are disappointed by declining profit margins and growth rates below their assumptions (combined with looking at their pathetic returns over the last 10 years) they will likely adjust the price. That adjustment could come fairly quickly (It would take a 30% or more drop from here just to get back to equities being priced to deliver real returns close to 5%) or by a combination of smaller declines and rallies going on for years, such as we have seen since 2002. That of course assumes inflation doesn’t become a larger issue (very much in doubt) and/or the pessimism doesn’t cause a large over shoot to the downside. When investors have been disappointed for a period of 10 years or more they have had a habit in the past of getting in very dark moods.
Hat tip: Abnormal Returns
Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.
