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Wednesday, May 22, 2013

Harvard Economist Gregory Mankiw Says" Stocks may be an especially good deal today"....Color Me Skeptical

In the Sunday NYT Harvard Prof. Gregory Mankiw admits that he is not much of a stock picker and correctly advises investors to steer clear of stock picking and diversify broadly through indexing...some good basic advice.

But then he makes a statement that indicates he isn't much of a market timer either. He makes reference to the equity risk premium and some recent research ".(my bold)

In 1985, Rajnish Mehra and Edward C. Prescott, both now at Arizona State University, published a paper in the Journal of Monetary Economics called “The Equity Premium: A Puzzle.“The Equity Premium: A Puzzle.” They pointed out that over a long time span, stocks have earned, on average, about 6 percent more per year than safe assets like Treasury bills. This large premium, they said, is hard to explain with standard economic models. Sure, stocks are risky, so you can never be certain you’ll earn the premium, but they are not risky enough to justify such a large expected return.

He then notes the following recent study as an indication that stocks may be a good value at present:

Stocks may be an especially good deal today. According to a recent study by two economists at the Federal Reserve Bank of New York, given the low level of interest rates, the equity premium now is the highest it has been in 50 years.

I think the study indicates quite the opposite...perhaps Prof is a poor market timer as well as self admitted poor stock picker.

First off at least in recent history the average equity premium is lower than the 6% cited above. As the NY Fed study notes 

he chart below shows the weighted average of the twenty-nine models for the one-month-ahead equity risk premium, with the weights selected so that this single measure explains as much of the variability across models as possible (for the geeks: it is the first principal component). The value of 5.4 percent for December 2012 is about as high as it’s ever been. The previous two peaks correspond to November 1974 and January 2009. Those were dicey times. By the end of 1974, we had just experienced the collapse of the Bretton Woods system and had a terrible case of stagflation. January 2009 is fresher in our memory. Following the collapse of Lehman Brothers and the upheaval in financial markets, the economy had just shed almost 600,000 jobs in one month and was in its deepest recession since the 1930s. It is difficult to argue that we’re living in rosy times, but we are surely in better shape now than then. 


It seems to me the authors show a profound misunderstanding of stock market performance in their above analysis. The best stock returns come when the market recovers from periods of deep pessimism When there is "blood on the streets" and doomsday forecasts are the conventional wisdom. That is the whole point of the equity risk premium, For those willing to take the risk of owning equities during that period they are most likely to get compensated for the risk 

Future returns from stocks are highest when valuations are low...and that of course coincides with periods of pessimism. 

It makes sense to look at the equity risk premium number in conjunction with current valuations

The valuation indicator that has the best predictive power is the Shiller p/e ratio which is charted below.

Over at analyst Samuel Lee a fellow fan of the indicator writes:

...My favorite valuation metric, Shiller P/E, averages real earnings over 10 years to smooth out the effects of the business cycle. At the S&P 500's current price of $1,600, Shiller P/E is 23, about 40% higher than its historical average. According to AQR co-founder Cliff Asness, the stock market's average 10-year real return from this P/E ranged from negative 4.4% to 8.3% annualized, and averaged 0.9% annualized. The low average reflects the fact that Shiller P/E tends to be mean-reverting.

The equity risk premium according to some shows stocks a "good value" relative to bonds, but the valuations seem to tell a different story.

The Economist  ran a piece on the same  study from the NY Fed  (my comments in parentheses) they wrote :

Is it possible to square the absolute(high risk premium) with the relative measures (high valuations and modest increases in profits) ? Equities may perform much better than government bonds, but only because those bonds will provide dreadful returns. The New York Fed researchers found that the main reason for the high risk premium was the exceptionally low level of yields. In America, 
Britain, Germany and Japan, ten-year bond yields are all below 2%

Even using current 10 year treasury yield of under 2%(instead of the t bill rate) with the current equity risk premium of 5.4% on gets a 7.4% expected return for equities. Measured against the extremely low current inflation rate of under 2% that would put expected equity returns right within their long term average range of 6-8% above inflation.

The Exonomist article  concludes as follows:
Still, because of the unappealing nature of likely bond and cash returns, it would probably take a shock to derail the equity rally in the near term. Such a shock could be economic (a sudden surge in inflation that prompted a change in monetary policy, say) or geopolitical (a wider war in the Middle East, for example). But for now, the bulls see no need to worry.

That may be a decent argument for no imminent crash but not a rationale for 18% return over the course of the 4 1/2 months year to date.

 Even if one accepts the equity risk premium and the rationale for stocks being attractive to bonds because of low interest rates one gets to an expected annual return for stocks of  5.4% (based on t bill rates of zero). That means returns for 2013 year to date are more than 3x the expected return for the year. It's hard for me to conclude that "stocks are an especially good deal today".

When the main reason for an asset rally is that "there is no place else to put your money" makes me nervous. In my view at a minimum it makes sense to review ones asset allocation and if necessary sell some US stocks to put allocations back in line buying some short term bonds and non US stocks. 

Valuation matters.

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