Various studies, beginning with Shiller (1981) have concluded that the volatility in the stock market is too great to represent forecasts of future dividends or other measures of cash flows of corporations. As memorably described by Shiller, the stock market appears to exhibit ‘excess’ volatility, namely volatility that cannot be attributed to rational factors and rather reflects (in the words of Keynes) the ‘animal spirits’ of investors.
Rare disaster models offer an alternative way to understand excess volatility. Rather than reflecting the day-to-day whims of investors, stock market fluctuations could reflect investors' changing views of the probability of a rare disaster. An increased probability of a disaster implies that future earnings are likely to be both lower and more risky. These effects combine to lower equity prices, even if a disaster itself does not take place. Thus, stock returns, which incorporate these probabilities, can be far more volatile than dividends or consumption, which reflect (primarily) the disaster itself.
I think this is a much more helpful way of imagining equity behavior than behavioral explanations of cognitive biases, fickle moods of fear and greed, and wildly fluctuating required return expectations. I also happened to see this at an interesting blog called Spontaneous Finance, written by Julien Noizet (the post I am excerpting is a guest post by Justin Merrill.):
The natural rate of interest is equal to the return on assets for corporations. Most economists that try to model the natural rate mistakenly do it as the risk free rate or the policy rate. This is a misreading of Wicksell since he identified the “market rate” as the rate which banks charge for loans, and the important thing was the difference between the market rate and the natural rate.
This all corroborates with my intuition - to begin with the required return on corporate assets and to discount from that to get to low risk securities, instead of starting with a risk free rate and adding risk premiums. As the Vox paper points out, there are many separate issues going on with equity valuations through a volatile episode, but, the net result appears to create a quite stable level of required returns on corporate assets. We can model equities based on (1) earnings, (2) growth expectations, and (3) the discount rate. If the sorts of risks about future changes in income in the Vox paper are manifest in growth expectations, equity valuations become kind of boring.
The discount rate appears to be quite stable over a long period of time - around 6-8%, in real terms, depending on the range of corporations included. And, there appear to be countervailing influences on growth expectations through the business cycle. There is a natural tendency for mean reversion, because equity owners are the residual claimants on national income, they tend to experience extreme income fluctuations through business corrections, which are basically disequilibrium episodes. If the economy does recovery, that disequilibrium will dissipate, and corporate income will return to its natural level as a portion of national income (which is also very stable over time). But, as Jerry Tsai and Jessica Wachter argue in the Vox paper, risks about the reliability of recovery are especially high during these contractions. These risks include the possibility of outlier events, and the ability of firms to handle them, that create a drag on probabilistic growth forecasts. In practice, the added risks related to contractions appear to generally mitigate the expectation of mean reversion, so that growth rates also tend to remain fairly stable over time.
This leaves earnings as the primary source of volatility in equity valuations, and, helpfully, this is a variable that is widely measured, tracked, and forecasted. As the chart above shows, corporate valuations and earnings move together most of the time. Even the large swings in valuations since 2003 have largely been in proportion to changes in earnings. There are two distinct periods where valuations were untethered from earnings. These periods coincide with unusually low real growth expectations in the 1970s and unusually high growth expectations in the late 1990s.* In other words, even in the cases where valuations fluctuated, a fluctuating natural interest rate (on corporate returns) is not the likely explanation.
Now, one could argue that this is simply a semantic distinction - that I am just taking "animal spirits" that Robert Shiller would identify as a fickle discount rate and re-categorizing them as deviations in the growth rate. But, even to the extent that that is the case, this framing makes equity markets much more simple and conceptually manageable. There is no need to endlessly argue about unidentifiable investor sentiments. The vast majority of relative equity valuations simply comes down to earnings. And, where there has been a persistent deviation from the expected valuation, there have been reasonably identifiable sources of deviating growth expectations. If you take a tactical position, you don't need to put a mood ring on the marginal investor. You just need to justify a different growth expectation. You don't even need to think about Treasury Rates, Equity Yields, or Equity Risk Premiums.
Equity valuations, compared to earnings, are roughly at the level trend that, with a little noise on either side and two distinct deviations, has been in effect for 50 years, and corporate growth expectations, which include significant foreign revenues, are 5 1/2% - a bit less than long term NGDP growth. A bearish position here based on "bubbles" seems wrong. A bearish position needs to depend on extremely low growth rates or a contractionary shock.
* I admit that the very low valuations of the 1970s are a bit of a mystery to me. An explanation that I don't quite trust, because it fits my political priors, is that this was the result of the pro-consumption public policy at the time. High inflation, together with policies such as high minimum wage levels and new public transfer programs, were geared toward the sort of pro-consumption goals that are still associated with a Keynesian paradigm. Possibly the result of those pro-consumption policies came at the expense of growth oriented investment.
But, what's interesting is that the low real growth expectations caused valuations to fall below relative earnings as much by pushing earnings up as by pulling valuations down. When expected growth is low, corporations require a larger portion of current income to satisfy investors. Future corporate growth expectations don't just create higher future incomes. They create higher relative compensation today because corporate owners substitute expected future cash flows for current cash flows.
And, look at what happened when the Reagan era supply side policies replaced the demand side policies of the 1970s. I think most people would be surprised to learn that nonfinancial corporate profits didn't top the 1979 level until 1992, after 12 years of the Reagan and Bush presidencies, during a decade when Democrats sponsored tax cuts and the New York Times was against the minimum wage. And, these are nominal figures while inflation was still high during this period. From 1Q 1979 to 3Q 1986, nonfinancial corporate earnings fell 60%, in real terms.
Part of this was due to the high inflation premium going to debt, and I have argued that when considering returns to corporate assets as a portion of national income, operating profits to Enterprise Value is more appropriate. So, here is a graph that adds interest expense and debt to the data. I have also adjusted the numbers with the GDP deflator. And, even with high interest payments included, real income on corporate capital declined from 1979 to 1986 and was just above the 1979 level in 1992.
In terms of the main topic of this post, using operating profit and enterprise value still tends to show valuations and profits moving together over time, but here the lag in valuation persists a little longer into the 1980s than it did when we just looked at profits and equity values.
And, we see the same result in the opposite directions in the late 1990s. There, the high growth expectations caused valuations to soar. And, since so much of the value of equities was based on future cash flows, corporate owners did not require current income to justify their investments. So, by any measure, profits were falling during the boom years of the late 1990s, well before the 2000 recession.
In addition to suggesting the downward influence that growth expectations have on current capital income, this also belies the cynical myth that financial markets shortsightedly chase the next quarterly earnings report at the expense of long term value. First, there is a consistent baseline of boring valuations that simply don't change that much relative to earnings. But, when they do deviate, they deviate in the opposite direction from this myth. When current profits were high at the expense of long term growth, equity values plummeted, and when current profits were low while firms plowed investment into highly uncertain long-term growth, equity values soared.
This is like one of those contradictions in consensus ideas that Marc Andreessen likes to tweet. Everyone simultaneously knows that (1) financial markets are obsessed with short term earnings and (2) financial markets push us into recessions by throwing billions of dollars at outrageous tech. businesses that have no prayer of ever making decent profits.