Updated: May 18, 2022
It is possible that we are now in an environment in which the falls in markets since last summer, particularly those in early December and throughout most of January, begin to have an impact on aggregate demand (which anyway was already somewhat insipid what with on the one hand the US nearer the end than the beginning of its business cycle and on the other hand China slowing structurally). If people or companies feel more uncertain as a result of market declines, they may reduce their spending or investment patterns which could cause a recession.
"If dividends are so stable, why are markets so volatile?"
How one judges whether this will happen and thus whether a protracted bear market looms is an almost impossible task. The global economy is an example of what is known as a non-linear complex adaptive system. Or to put it another way, it’s unpredictable. Fear can spread like wildfire, feeding on itself. And fear can be rational, as in bumping into a tiger, or it can be irrational, where one is fearful for no reason other than that others are fearful. Whether the crowd’s fear is itself rational is neither here nor there. Why wait to find out? It is human nature to run first and ask questions later. This reminds me of the conversation in Joseph Heller’s classic novel Catch 22 between Yossarian and Major Danby: “But, Yossarian, suppose everyone felt that way?” to which Yossarian replied, “Then I’d certainly be a damned fool to feel any other way.” You cannot argue with the logic.
You may think me barmy but below is my favourite chart (Chart 1). It depicts book values over the last 15 years of portfolios invested on 31 Dec 2000 in various MSCI indices, rebased to 1. In other words, no account is taken of subsequent movements in equity markets, only of dividends received. The series are calculated by simply dividing the total return indices by the respective capital only indices. Think of them as the accumulated value of dividends received (if you look carefully you can just about discern a slight flattening of the lines in 2009 when dividends fell, meaning that the rate at which dividends accumulated fell slightly).
The point of the chart if you haven’t realised it is this: if dividends are so stable, why are markets so volatile? (I keep a copy of this chart pinned up on the wall near my desk to remind me to keep wondering about this question). The fact is that dividends in aggregate rarely fall and when they do they recover quickly. Why do markets sometimes behave as if dividends are going to dry up for good when the likelihood of this happening is so remote? Furthermore, why worry about this possibility when the circumstances that would cause it such as a nuclear holocaust or an asteroid hit would almost certainly cause you to worry about things other than the value of your portfolio. The answer to both of course is: human nature. Humans run first and ask questions later.
What this means of course is that if you step back and behave rationally, you can take advantage of the irrational behaviour of the crowd.
In 1981 Yale’s Bob Shiller wrote a paper titled “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” In the paper, Shiller noted that it had “often been claimed in popular discussions that stock price indexes seem too “volatile,” that is, that the movements in stock price indexes could not realistically be attributed to any objective new information [about dividends], since movements in the price indexes seem to be “too big” relative to actual subsequent events.”
To illustrate the point graphically, he plotted (see Chart 2 below) the S&P Composite index, P, against the present discounted value of the actual subsequent real dividends, P* (both series were de-trended so one could more clearly see the variations around the trend). What is clear from the chart is that the answer to the title of Shiller’s paper is ‘yes,’ stock prices do indeed move too much to be justified by subsequent changes in dividends.
Shiller’s paper dispels the notion that stock markets are efficient. Markets are simply too volatile to be justified by big changes in discount rates (real interest rates) or by people being rightly fearful of collapses in future dividends. Given that dividends haven’t collapsed in the past and that the sample size is large, it is highly unlikely that they will in the future. Companies have the ability to adapt to prevailing conditions. In the face of lower earnings, they can cut pay-out ratios in order to maintain dividends. They can cut capex, costs, or prices. In the face of higher inflation, they can raise prices. All this means that companies in aggregate have a remarkable propensity to deal with and recover from recessions.
Shiller’s key conclusion is that markets are not efficient. If markets were efficient, they would track much more closely the present value of future dividends, something that can be reasonably estimated and which is very stable. Thus when markets veer a long way from the present value of dividends as they have a tendency to do, they will naturally be drawn back towards it, also known as mean reversion. This means it is possible for tactical asset allocation to add value.
To illustrate further this tendency for markets to recover, I have investigated how the US equity market has behaved following instances when it has fallen by various amounts in relation to its all-time high. Specifically, I have calculated how long it has taken the S&P 500 index to recover its all-time high once it falls certain percentages from said all-time high and what the annualised return has been during these periods. As of 20 January 2016, the S&P 500 was 12.7% below its all-time high attained on 21 May last year. Thus, I have considered all other periods since 1955 when it has fallen by the same amount, as well as by 20%, 30% and 40%. The results are shown in Table 1 below.
On the 13 occasions since 1955 when the S&P 500 has fallen by 12.7% from its all-time high, it has taken an average of 581 days (roughly 2 years) to regain its high, during which time the annualised return has been 6.3%. This is in fact slightly lower than the long-term average of 6.6%. However, when the index falls by more than 20%, the annualised returns to get it back to its all-time high have been well above 6.3%.
What this means is that judging by the history of the last 60 years a decline in the order of what we have seen over the last 8 months should not prompt one to increase equity weightings. However, if the market falls further, one should begin to get excited. And one should continue to get more excited the further the market falls. Gamblers call this a Martingale strategy and it works when applied in markets where there is mean reversion as is the case in equity markets.
Although it is certainly possible that we have entered a protracted bear market in equities, I don’t believe this to be the case. Economies around the world still in general have scope to grow, as evidenced by negative output gaps, low inflation, and unemployment rates that can fall further. Monetary policy can remain supportive (as we go to print Japan has introduced negative interest rates). And there is also scope to boost fiscal policy if necessary, though this would more likely be a response to a recession rather than slower growth. As for equity valuations, dividend yields are well above historic averages, which in the absence of a nuclear holocaust or asteroid hit represent good value. Thus, I don’t think markets will continue to fall for much longer but if they do we will be ready.
Published in Investment Letter, February 2016
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.