Active management and the predictability of markets #2

In this second post on 'market predictability' I look at some of Prof Robert Shiller's work. Shiller was a co-winner of this year's Economics Nobel Prize along with Prof Eugene Fama (whose work I considered in the last post). To many it seemed a mistake - or at least a contradiction - that these two shared the prize. Fama is best known for the finding that markets are essentially efficient, or rather that they are once trading costs are taken account of. Shiller on the other hand found the opposite, that there are patterns discernible enough to profit from. How could they both win the prize having derived diametrically-opposed results?!

Although Fama is known for his early work, which labeled him as a believer in efficient markets, his later work revealed more pronounced patterns that he nowadays seeks to profit from through his work with Dimensional Advisors. These patterns relate to the size and valuation of stocks (he found that small caps tend to outperform large caps and high book-to-price stocks outperform low book-to-price ones).

In a 1981 paper, Shiller showed that stock prices move much more than they should if they were purely a function of subsequent changes in dividends (also known as the "efficient markets model".) Later, in 1984, he showed that there was a positive correlation between the current dividend yield and subsequent returns. In other words, when the dividend yield was high, the subsequent one year price movement was higher than normal, contrary to the efficient markets model which implied that "a high current yield should correspond to an expected capital loss to offset the current yield".

Somewhat ironically, Fama, in collaboration with Kenneth French, showed in a 1988 paper that dividend yields had even greater predictive power over longer time frames. While dividend yields explained 15% of subsequent one year returns, over five years they explained 60%.

Shiller's work on asset prices, and in particular his 1984 paper, "Stock Prices and Social Dynamics", paved the way for the emergence of the field of behavioural finance. Indeed, although the term "animal spirits" was coined by John Maynard Keynes in his 1936 publication, "The General Theory of Employment, Interest and Money", it was popularised only later by Shiller himself and a colleague George Akerlof in their 2009 book "Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism".

That markets are not rational or efficient now seems obvious though it took several decades to challenge the widely accepted principle that human beings, the agents of markets and economic systems, make rational decisions. Charlie Munger, Warren Buffett's right hand man, famously remarked "If it isn't behavioral, what the hell is it?" though this was in reference to economics rather than financial markets.

Although not mentioned in the paper that provided the background to the Nobel 2013 award, Shiller is also now associated with another predictive indicator, the cyclically-adjusted price-to-earnings-ratio (CAPE), or the Shiller P/E. CAPE is calculated by dividing the current price by the average 10 year real earnings and is based on the work of Benjamin Graham and David Dodd who argued in their 1934 classic, Security Analysis, that more meaning could be garnered by using smoothed earnings rather than current earnings, since when earnings were depressed the market would anticipate them recovering and thus trade on a higher multiple. Taking the ten year average meant that one should always or at least most of the time be including both a peak and a trough in earnings and thus keep comparisons between current CAPE and historic CAPEs on a like-for-like basis.

So, what are current dividend yields and Shiller P/Es telling us about likely future returns from equity markets? Annoyingly little, if Robert Shiller's own words are anything to go by. Speaking earlier this year in Davos, he said that his "CAPE ratio [for the US equity market] is over 25 which by historical standards is high but is not record high; it got up to 46 in the year 2000." In other words, over the long term, equity returns will be below their historic average in the long term but in the short term could outpace it as the CAPE continues to rise towards its historic high.

There is also a reasonably strong inverse relationship between the CAPE and the inflation rate (other than when inflation is negative) so it is possible that if central banks are able to stop the world from slipping into deflation and weak aggregate demand prevents inflation from accelerating sharply, a higher CAPE would be justified.

Prof Jeremy Siegel, famous for his 1994 classic Stocks for the Long Run, is another fan of the ratio but argues that the data on which it is now based are unreliable. Adding back write-downs incurred by financial firms in 2008 and 2009 raises the ten year average and thus lowers the CAPE to a level which he says suggests US equities are still cheap.

John Hussman of US firm Hussman Funds also argues that earnings have been distorted (downwards) by accounting standards such as FASB 142, introduced in 2001. This standard "offers guidelines on adjusting the value of intangible assets, instead of keeping those investments on the books at cost and gradually amortizing the value over time. It's argued that during the last couple of recessions this new accounting rule has caused companies to aggressively write down the value of their intangible assets, impacting earnings, therefore pushing profits lower, and biasing P/E ratios (like the CAPE) higher." However, Hussman finds plenty of other measures that suggest US equities are now overvalued.

The conclusions of both Shiller's and Fama's work is that markets are most or only predictable at valuation extremes. Although it is hard to know whether market valuations will reach or even exceed previous extremes, it is fair to say that they are currently a long way from them. While this does not therefore support a case for being bearish, nor does it support one for being particularly bullish. That, sadly, is often the way with markets.