I single it out because outsmarting the smarts with simple thinking is very No Monkey Business. In fact, the same data has regularly featured in No Monkey Business posts since 2006 (about a year behind Paulson) as an obvious parallel with the Nationwide deflated index of UK average house prices which I regularly monitored on the No Monkey Business blog from about 2002. Just don’t ask me where my $4b is.

What drew me to the study of the trend and deviations from trend in real house prices was that it was itself a parallel application of an important insight about equity returns: historical time series for ‘real total returns’ (ie cumulative indexed performance with income reinvested, deflated by a consumer price index) contain valuable predictive information for investors, and more so than conventional valuation measures like price/earnings multiples and dividend yields. This was one of the big but simple ideas set out in my book in 2002. Since 1999 it has been the basis of horizon-specific probabilistic return projections in a model we now use to manage Defined Outcome portfolios.  

Such an apparently naive solution to a complex problem is deeply offensive to most investment professionals as it implies redundancy for much of their industry. I naturally therefore warmed to the naivete of the Sunday Times account, as typified by this extract.

'Everybody said home prices never had declined on a nationwide basis except during the Great Depression,” Paulson later recalled. He sent Pellegrini scurrying back to his cubicle to determine how overheated the property market was.Tracking interest rates over the decades, Pellegrini concluded that they had little impact on house prices. But as he reviewed academic and government literature and figures, Pellegrini grew frustrated. He couldn’t quantify how excessive housing prices were or show when a bubble might have started. He couldn’t even prove the price surge was distinct from historic moves.Grasping for new ideas, Pellegrini added a “trend line” to the housing data; this illustrated how much prices had surged lately. That’s when Pellegrini took a step back to view things over a longer period, ordering up data on home prices all the way back to 1975. Suddenly, the answer was as plain as the paper in front of him: housing prices had climbed a puny 1.4% annually between 1975 and 2000 after inflation was taken into consideration. But they had soared by more than 7% a year in the following five years, until 2005. The upshot: US home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Pellegrini’s figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop was likely to be brutal. Pellegrini sat upright, staring at his trend line, amazed at how simple and clear it was.The next morning, he raced in to show Paulson. “This is unbelievable,” said Paulson, unable to take his eyes off the chart. “This is our bubble. Now we can prove it.” Pellegrini just grinned, unable to mask his pride.'

The standard source material for real house prices, deflated by general inflation as measured by the CPI, was the S&P Case-Shiller Index. Pellegrini refers to data going back to 1975 but there is in fact earlier data which I came across a little later in the form of index creator Professor Robert Shiller’s submission to a Congressional commitee. In September 2006 I posted an item on the No Monkey Business blog called US house prices: you thought we had a problem which included a chart of over one century of real prices for single-family homes.

It was important that the data be real. Real prices are perhaps better decribed as relative house prices, because they measure prices relative to general price inflation. But even real price series were rarely publicised because of people’s obsession with changes in the price level, treating house price inflation as the key information rather than the level of relative prices itself. This was a widespread problem in the US just as it was in the UK. I still berate newspaper editors for repeating this error.

As I pointed out in my article, fitting a regression trend to the long time series data was not helpful because there were several distinct phases of price behaviour, including just two since the end of WWII, up to and after about 2000: no real growth followed by a growth explosion. In my article, I contrasted the absence of any overall trend in US real house prices prior to 2000 with the trend in post-war real prices in the UK, which has been fairly persistent at about 2% per annum, in line with growth in personal incomes.  The 0% trend in the US for some 50 years means that relative to personal incomes US housing had become progressively more affordable. I agreed with Prof Shiller’s interpretation that this was due to easy access to new development land, an endowment we clearly do not enjoy in our planning-constrained small island.

More important, the only plausible explanation for the change in price dynamics after 2000 was the change in credit availability. The fact that people wanted to believe in endless rapid growth, a new twist to the American dream, was a necesssary condition but it also required bankers and mortgage investors to throw caution to the wind or the boom would have simply run out of fuel. And it was the massive stock of derivatives created on the back of securitised mortgages, two symptoms of the credit-induced madness that overtook the housing market, that gave Paulson & Co the instruments, in the form of credit default swaps (insurance contracts that would pay out if the underlying securities fell in price), which had the inherent leverage to turn £147m into $20b.  That was convenient but it was also smart and gutsy.

Is he right?

In this increasingly popular view, the actions by governments to pump money into the stalling financial system are seen as giving stocks a reprieve before they reached the sort of valuation levels that properly discounted the post-credit crunch realities facing economies and businesses. Hence the anxiety now as the patient looks to be coming off life support. 

John Authers’ preferred measures of value, using replacement value of assets (Tobins q) and a trailing 10-year average of earnings, supports the story that US equity investors, like the banks, got lucky and were bailed out before reality had sunk in to share prices.

I don’t think we can agree with that. Our own measure of value suggests that the last move down in the S&P at the start of 2009 took the market to an extreme level with only a few historical precedents in any major equity markets, all equally important as long-term buying opportunities.

Whilst we attach a great deal of importance to our measure of value as a basis for forecasting long holding-period return probabilities that can be used in asset allocation, it still does not mean there is a negligeable chance that the S&P will fall through the earlier low. Though it would be unprecedented for the US market, it happened in the UK in 1974 and in Japan in the 90s and again in 2003. What can happen in one place can happen in another.

There are also several historical examples where extremely high predicted value has persisted for a decade or more, Japan being one but Continental Europe in the late 70s and early 80s is a less familiar one, being disguised at the time by high inflation.

Though the FT piece was about the market most likely to influence the general direction of global equities, it is worth noting more parochially that on our measure the FTSE All Share Index is the least undervalued of all the major markets and did indeed recover well before reaching a historically exceptional valuation.

Lateral thinking about equity valuation

We agree with John Authers that Tobin’s q and trailing 10-year earnings will dampen the effects of extreme cyclicality in current fundamental inputs to valuation, particularly reported earnings. As an accompanying chart in his column showed, reported earnings in real terms reached a low point last seen in the 1930s although clearly this is not what has happened to ‘earnings power’ for American business.  The q ratio dampens variance simply because replacement value of assets is very stable, so the significant information comes from price change. Averaging earnings over several years will also dampen the valuation variance but is transparently arbitrary and may also leave price variance as the important information. These may therefore be better than conventional price/earnings ratios when earnings are disturbed but they are still not rigorous indicators of extreme valuation, high or low.

As market historians, Chris Drew and I have since the late 1990s adopted a lateral approach to equity market valuation, formalised in a return-generating model called Lambda. We ignore fundamental inputs, because of the measurement problems, in favour of tracking the path of achieved real total returns from each market and comparing it with its own long-term trend, using ’best fit’ regressions. The model has not been invalidated by subsequent return behaviour and has indeed handled several episodes of extreme valuation very well.

On this measure, the recent low for the S&P was as low as the previous extremes of the early 30s and 40s as well as 1974 which was revisited (in real but not money terms) in 1982.

Fig 1 shows the S&P continuously-compounded logarithmic returns with gross dividends reinvested and deflated by the CPI from 1925, as an index. The whole-history regression trend (colour) is 6.8% pa but the hindsight-free trend using data up to each point in the series (colour) was above or below this as a function of the particular period. In my book I showed a Wilshire series for US equities for nearly two centuries that revealed a similar trend in both centuries, in spite of massive contextual differences. Data for other major equity markets also suggests about 5-7% pa as a trend, with much narrower dispersion of the differences than economic context and culture might suggest. Global evidence suggests regression trends are not just a statistical accident but an economically sustainable quantity that is a core element of the equity return process. We believe there are strong theoretical underpinnings for this, based on both economics and risk aversion.

Fig 1 Trend and deviations from trend in real equity returns: S&P 500

This idea of sustainable real equity returns over long holding periods is really important. It conflates into a single measure two crucial influences on returns: i) fundamentals (like earnings and dividends) and ii) investor behaviour changes (like risk aversion, sentiment and momentum following). Historically, even over long holding periods, the second set of uncertainty sources has usually dominated the first, which makes the traditional focus on fundamental inputs look odd. If jointly the two sources of uncertainty lead to bounded deviations from trend, as a further core element of the return process, we do not need to disaggregate them to model either returns or risk.

Fig 2 expresses the level of the real total returns index as a ratio of its own trend, or detrended, which we call the Market Value Ratio. We use this as a basis for adjusting upwards or downwards the mean expected returns extrapolated naively from the trend alone. Low price denotes high value and high future returns and vice versa. By making some assumption (itself based on historical analysis) of the time-dependent reversion to trend, we can estimate real return probabilities for every holding period as often as we gather new historical return data. The actual frequency is monthly.

Fig 2 Market Value Ratio: S&P 500

What can we do with value?

Fig 2 makes the point of this post that the S&P low in March last year was extreme. This observation was sufficient to justify exceptionally high expected future returns, provided long holding periods could be assumed. For investors with naturally long horizons, this amounts to a lot. It is why we added with confidence to clients’ total equity exposures up to the low point, while others were selling, and reduced them either side of this recent year end. See Is your manager doing a good job? (22nd January). 

Observing extremely low value by March 2009 may even have been enough to warrant assigning a very low probability to further downside risk over short horizons, which would also amount to a lot if, it could be relied on.  We do not believe it can. We prefer to treat short holding-period returns as a ‘random walk’. That was not the basis of our decision to buy.

An aside for more numerate readers: short-run returns, whether deflated or not, also have the highly inconvenient statistical characteristic of fat tails, or extreme outliers that would not be predicted if assuming a normal distribution. Long holding-period real returns, on the other hand, appear to be normally distributed. 

We sympathise with John Authers who is obliged (as a good journalist rather than a good story teller) to remind us that even a ’true’ valuation of the market tells us very little about the chance of the market falling or rising or staying the same over the next few years. This might read as ’sitting on the fence’ but it is more insightful to see that good valuation measures simply have restricted uses.

For us, as financial planners and even as portfolio managers, using them to project long holding-period real outcomes is actually more important than using them to try to time markets. Imagine yourself in 20 or 30 years time looking back and deciding you got the outcomes you wanted and planned for. Is it most likely you will credit the many market timing decisions that made up the path your money took or rather making the right long term decisions? We have no doubt and we don’t think our clients do either.

The chances are you or your adviser will be following the money already flowing into China and the wider Asian area. Data collected by the Investment Management Association shows that through 2009 retail investors in the UK moved increasingly large sums into funds investing in emerging markets and Asia (ex Japan), to the extent of about one quarter of their net purchases of equities. For both sectors, these are record flows. The vast majority of the flows have been handled by intermediary firms, not self-directed investors. US retail investors have similarly shown record interest in China, India and smaller Asian markets.

Though the flows are enormous for the sectors, the stock of holdings is still relatively small. But that is the point about China and the other large economies playing catchup: India and Russia. They generate a sense of anxiety that personal portfolios ought to look more like the global size and importance of different economies. As if that was not enough, the idea of participating in much faster growth is even more compelling when investors see Western economies being held back in the growth stakes by the lasting loss of productive potential inflicted by the credit crisis.  It is a good story but it is also a trap.

The growth trap

The growth trap is one that through history has caught out professional investors as well as retail investors. This suggests it is not as simple as professionals: smart, amateurs: dumb. It has to do with something that divides professional investors too: understanding the nitty gritty of business planning with financing costs allowed for. You can be smart by understanding how to analyse growth dynamics, whether for single companies or country equity markets as a whole. Or you can be smart by understanding the mistakes that others are making and exploiting them. In competitive fund management, good analysts often have to go with the flow, or momentum of markets, and hold positions much longer than fundamental value warrants, because of the need to keep up. Mistakes can be made even by smart investors, either in the analysis itself or in the gaming of other investors’ activity. Self-directed investors also get the analysis wrong but then usually compound that error by arriving late enough at the party to provide the sucker money that lets the smartest game players get out near the top.

In terms of its analytical roots, the growth trap is all about the difference between ‘top-line’ growth, say GDP for an economy or sales for a company, and ‘bottom-line’ growth, as in the cash flows and accounting profit underpinning each share owned by an investor. This difference between top and bottom line growth is largely explained by the irritant of having to finance growth. This is an irritant because there is almost always a gap between the opportunities for physical expansion (superior) and return on capital (average). This is because return on capital is determined by competition and scarcity which are largely independent of growth opportunities. Indeed, if anything, the more obvious the growth opportunities, the more likely competition will displace scarcity and push return on capital below the level required to finance growth without dilution.

Dilution is the effect on existing shareholders of issuing new shares to plug the gap between profit generation and capital investment. Dilution can be avoided by plugging the gap with debt, but only up to a point. And in any case the investor’s actual achieved return should then reflect the additional risk they are asked to bear.

High growth economies

The dilution issue for companies scales up to whole economies. There is overwhelming evidence from achieved real returns from different markets that the return-generating process is essentially the same but neither return differences nor risk differences within this system are explained statistically by top-line growth differences. The world of investor returns is much flatter than naive observers would assume but that is consistent with profitability internationally being much flatter.

The evidence is in deflated equity indices for some 20 markets for much or all of the 20th century. In my book I also showed a chart of the fitted return trend for a Wilshire index of US shares from 1820 to 1999 and there was esentially no difference in the returns earned in the early period, when America was a fast-developing but already large economy, and the later period as a mature economy and stockmarket.

These general observations apply to the BRIC story even though the story appears to have particular explanations that are not typical in past data histories. The growth opportunity is seen as being a function of the gap between

• the actual and projected size of the economy and its importance in a global context and
• the total size of the stockmarket, being the value of the listed companies in the fast-growing economy.

For China, India and Russia the gap is seen as unusual in origin because long periods of more or less socialist systems, for up 80 years, destroyed productive capacity. Errors in economic management and perverse incentives continued only as long as they did because these countries could feed themselves, up to a point. That takes large populations and land mass including, to survive the worst or longest mismanagement, indigenous industrial raw materials.

Though Brazil is also put together with these to form ‘the BRICs’, its growth story is more to do with riding a commodity wave than having an obviously less well-developed and poorly capitalised group of publicly-traded companies. Though it is not the same sort of ‘corporate gap’ story, Brazil does share with India a long history of disappointment in realising its productive capacity, even with less state control of production than China and Russia.

The change in economic system that has the potential to realise the catchup possibility does not need to take the same form, as all modern systems are politically constrained rather than free markets. Indeed, though emerging capitalism is very different in China from the West, it is not dissimilar to the Japanese system, yet the equity return process in Japan throughout its peacetime history appears to be the same as in the West.

Our argument is not with the catchup story but with the implications for realised future investment returns. The naive assumption is that the gap will be filled by higher higher returns for the owners of the existing companies. This could not be more wrong. The gap will inevitably mostly be filled by new capital, whether for existing or as yet unformed businesses. It is in this respect no different from the growth trap in any growth economy. The financing problem does not go away just because these are large economies held back by bad government.

Valuation

If the return process is the same, it is the valuation at points of entry and exit that will mainly explain holding-period returns, not the sustainable return trend itself. But if typical investor assumptions about future returns are based on a mistake, it follows that there is a risk that valuations will be too high.  This presents itself as an opportunity to game other investors over the short term but also as a risk of misallocation of personal capital over long holding periods.

We show below the real total return of the MSCI Emerging Market Index as an index (base 100 in December 1987), firstly as published in US dollar terms (orange) and secondly in real terms, deflated by US CPI (green). The second series is intended to correspond as closely as possible to our real return measures for developed markets. These follow the logic of a global model of real total returns in which the trend matters because of ‘mean reversion’ but the deviations from trend explain more of holding-period returns. If there were no net trend of either currency appreciation or depreciation over the period, differences in local-currency valuation would translate into future real returns to investors from other countries. In fact, holding-period real returns for international investors are also explained by differences between the actual exchange rate movements and changes in the ‘real exchange rate’, as derived from any gap between the two countries’ domestic inflation in the same period. Using US deflated returns for emerging markets is realistic from a global valuation perspective because the dollar is the key nominal and real exchange rate for emerging economies.

The real growth trend (broken line) is 6% pa which is almost exactly what we would expect from a developed economy’s stock market (even though this basket of markets across several geographical regions has shown higher volatility than an individual developed market).

The latest ratio to trend is 120%. It is not exceptionally high relative to previous deviations from trend but it needs to be seen in the context of much lower grow expectations for developed markets. The equivalent ratio of trend returns is currently 96% for the UK which is the most fully-valued of them all. The European ratio is 80% and the US 75%. Only Japan is priced for very low expectations, for reasons most investors will be familiar with, with a ratio as low as 44%. These detrended measures of value deviation since 2000 (the last peak of overvaluation) are shown below.

Our own measure of value is confirmed by a conventional fundamental measure that is very relevant if an investor accepts that the investor return world is relatively flat because corporate returns are relatively flat: price divided by the carrying value of equity capital in the balance sheet. Differences in price to book value ratios can only be rationalised by profitability differences.

Price to book value multiples of around 3-5 times in Chinese stocks (the range being between those available or not to foreigners), albeit lower than 6-7 times two years ago, are on a par with Japan at its 1989 peak. Even the banks, whose return on equity is surely not many multiples of banks in other economies, trade on ratios between 2 and 5 times book value. The MSCI India index ratio is 4 times. The MSCI BRIC index ended the year on 3.8 times book.

China fragility

If we had to pick candidates for major capital allocation errors of 2009, they will almost certainly appear somewhere in China’s economy. Though our argument here is not with the top-line growth, the signs of capital misallocation are enough to make a China blow-up plausible.

Any Japan analyst will surely be struck by the similarities with the way Japanese banks and companies misallocated capital throughout the 1980s and 90s, driving down marginal returns on capital even as high levels of capital investment continued. For households, the trap lay in both stockmarket speculation and rampant house prices. These too are echoed in China.

Any serious concern about the banking system in China will spring the valuation trap much quicker than if left to the typical cycle of equity momentum. There is always some risk in trying to be smart by gaming other investors, as people found out when the bubble burst in housing and credit markets in 2007 when levels of equity valuation were far from extreme.