Here We Go Again …

Daniel Murray is Global Head of Research at EFG Asset Management. In this article, he explains how valuation data can provide an anchor when projecting future bond and equity returns.  Since the calculations were first made, the S&P 500 has risen to approximately 1240 (December 2011), but the conclusions remain broadly valid.


  • Recent equity market action has been uncomfortable but, having experienced the pain, we recommend calm – avoid knee jerk reactions.
  • At current valuations, long term returns from US equities look reasonable and certainly much more attractive than those available from government bonds.
  • Yields on government bonds may fall further from here if the chaos persists but the medium term opportunity cost of being underweight government bonds is low.
  • Market bottoms are, by their nature, highly uncertain beasts associated with elevated volatility. The bottoming process usually takes some time and it is possible that recent lows are retested before positive trends reassert themselves.
  • Structural headwinds to the market stem from two primary (related) sources: European sovereign debt problems and ongoing deleveraging. We do not expect either of these headwinds to be resolved quickly and they will therefore act as a constraint on market growth.
  • The economic data has deteriorated recently although there are also some indications that the situation is not as bad as markets have priced in. We do not expect a double dip although the probability of one has increased.
  • We will continue to monitor markets and the data closely. Until we witness further meaningful deterioration, we expect to maintain current equity weightings in our portfolios. It is important to maintain a disciplined investment approach through this difficult period.


Market action of the past few weeks has been exceptionally volatile, albeit less so than at the depths of the financial crisis in the fourth quarter of 2008 when Lehman Brothers filed for bankruptcy. The banks are once again at the centre of this storm, with the focus having shifted from US to European financial institutions. Human beings have evolved over thousands of years to react to such extreme situations via the “fight-or-flight” response. This means that decisions over whether to stay and fight against adversity or to cut one’s losses and run are highly instinctual.

In current circumstances the sense of helplessness felt by many investors against the might of the market is likely to be encouraging flight and we are sympathetic to this discomfort. Nonetheless it is important to maintain a sense of perspective, something we attempt to achieve in the observations below.

  • Long Term Equity Return Expectations. With earnings expected to reach around $97 for 2011 and the S&P500 trading at around 1140 (at the time of writing), this puts the prospective multiple at just under 12x. This is not outrageously cheap but it is definitely on the right side of the expensive:cheap divide.
    A more conservative approach (that does not rely on forecast earnings for the remainder of 2011) uses national accounting data and then adjusts for the cycle; if earnings are elevated (depressed) because of a cyclical upswing (downswing) this approach adjusts them down (up) and calculates a market valuation accordingly. We have found this a useful tool for anticipating equity market returns over the next ten years. Chart 1 shows this measure together with implicit ten year ahead forecasts.

Chart 1. Cyclically Adjusted Valuations and Expected Returns.

Source: Federal Reserve, Bureau of Economic Analysis, Bloomberg, EFGAM calculations

The red line in the chart is actual ten year ahead returns. It stops in 2001 because that was ten years ago and it is not possible to calculate returns over periods that have not yet happened. The grey line is the cyclically adjusted PE ratio and the green dotted line is the forecast implied by the cyclically adjusted PE ratio. Thus, in the second quarter of 2001 the model was anticipating average annualised returns of -3.2% over the following ten years, taking into account inflation and dividends, and actual returns were -2.9%.

The current cyclically adjusted PE ratio is anticipating average annualised real returns of +3.4% over the next ten years. This is not as high as during the lows of the financial crisis in late 2008 and early 2009 when annualised returns of around 7.0% were expected but it does represent a perfectly attractive inflation adjusted return. Of course what this model does not tell you is what volatility one might expect to be associated with this return – markets do not travel in straight lines.

However, the model does indicate that, if one looks though short term gyrations, expected returns from equity markets look reasonable. There may well be better times to buy but the model suggests that owning equities at these levels will result in satisfactory returns.

  • Government Bonds. Balanced portfolios usually have some exposure to equities offset by exposure to government bonds. The theory is that during times of stress the two are negatively correlated such that government bonds rally when equity markets fall. That has certainly been the case recently. A paradox of this analysis is that the lower government bond yields fall, the lower long term returns to be expected from them.

Chart 2. Bond Yields and Prospective Returns.

Source: Bloomberg, EFGAM calculations

We showed in a previous report how the five year Treasury yield provided a very good forecast of the returns one could expect from government bonds over the subsequent five year period – see Chart 2. With the five year US Treasury currently yielding less than 1.0%, long run prospective returns from government bonds look poor. It is important to note that this is not a forecast that yields will rise sharply from here – in the short run they may well fall further if market volatility continues. We note though that the opportunity cost of not being invested in government bonds is low even if yields do continue to fall.

  • Market Bottoms. The marketing bottoming process is complicated. At some point asset prices fall so far that the perceived risk is offset by the potential returns, at least to some investors. However, no one knows exactly when this happens. By its nature this process is highly uncertain; if it were obvious that assets were cheap then everyone would be buying and prices would never fall so low in the first place.
    Price volatility would be greatly diminished and long run returns would be reduced. In practice, it is hard to identify market bottoms because of the uncertainty implicit in them. What we do know is they tend to be associated with a period of heightened volatility as the balance shifts from sellers to buyers.

Chart 3. Market Bottoms and Volatility.

Source: Bloomberg, EFGAM calculations

To illustrate this point Chart 3 shows how market bottoms in 2002 and 2008 were both associated with relatively prolonged periods of elevated market volatility. We note further that the market did not reverse suddenly from a low but in both instances spent a period of time trading around the lows before accelerating from there.

Unfortunately it is difficult to tell if current volatility is associated with a market low or if it is the precursor to further declines. If experience is a guide, it would not be unusual for the recent lows to be retested before an uptrend reasserts itself. Given the headwinds markets currently face it is not impossible that the market takes another leg down although this is not currently our core view. We remain alert to this possibility and will be monitoring markets and associated data closely.

  • Headwinds. In a recent report we highlighted various risks investors must currently evaluate. We expect European sovereign debt problems to continue to punctuate the investment landscape for sometime with the endgame probably requiring much greater ECB involvement. Until then a large shadow will be cast in particular over European financial institutions but also over financial institutions in other countries. This will limit the pace of any equity market gains.

The ongoing deleveraging process also represents a risk and will be a constraint on economic growth. History suggests that economies take on average something like six or seven years to recover from financial crises as leverage is unwound to more sustainable levels. Given that we are around three to three-and-a-half years from the start of the most recent financial crisis, this would suggest that we have another three to three-and-a-half years to go before the situation is properly resolved. Moreover, the large and global nature of the recent financial crisis may mean that it takes longer on this occasion. This too will act as a headwind.

Chart 4. Probability of Recession Implied by the Yield Curve Slope

Source: Federal Reserve Bank of New York

Short term uncertainty over the economic environment has also escalated recently and with it some question marks have appeared over earnings estimates for the remainder of 2011 and 2012. To be sure there certainly has been some evidence of economic weakness recently such as a rollover in purchasing managers’ indices.

There have also been some reasons to feel more optimistic such as a pick up in corporate and consumer loan growth as well as continued growth in leading indicators. Our view remains that we do not expect a double dip but we cannot rule one out and we will continue to monitor the data carefully for signs that the situation is deteriorating.

  • What to do. Maintaining a disciplined investment approach is important in such situations as is keeping a longer term perspective on asset prices and implied potential returns. As the famous Warren Buffett quote goes “Be fearful when others are greedy and greedy when others are fearful.” This may mean stomaching some short term volatility but one only has to look at Buffett’s track record to realise what a sensible approach it is.
    Nevertheless, behavioural biases are deeply imbedded in the human psyche and, however rational such quotes may seem when markets are calm; they are much harder to adhere to during the turmoil associated with sharp falls. Our central view, therefore, may be summarised as one in which equity markets are going through a volatile bottoming process with some risk to the downside. We will continue to closely monitor the data for signs of deterioration but in the meantime have maintained a constructive position on equities in our portfolios.