Swedroe: Election Revives Old Myths

November 15, 2016

The results of the U.S. presidential election not only surprised almost all the gurus who were saying that a Hillary Clinton victory was a sure thing, but also those forecasting that, if by some miracle Donald Trump won, a stock market crash was bound to occur. Prior to the election, I had received many inquiries from investors worried about the market and what they should be doing if Trump won the presidency.

It turns out market gurus were right about one thing: The DJIA futures market crashed by more than 800 points in the first moments after it became clear that Trump was going to come out ahead.

Election Day

On Election Day, Nov. 8, the DJIA closed at 18,333. Defying the gurus just two days later, not only had the DJIA recovered from the more than 800 points it lost, but it closed at 18,811. In other words, in just two days it had rallied by about 1,300 points (more than 7%), contradicting many so-called experts who had predicted a 10% or more decline.

I can only wonder what investors who panicked and sold are doing now. It’s highly unlikely, in my opinion, that they will have a good investment experience (unless they either get lucky or learn from it). And there is an important lesson here. It involves the all-too-human problem known as hindsight bias.

On Monday morning, we all make great quarterbacks. With the benefit of hindsight, the right play to call is obvious. Unfortunately, we also have a tendency to exaggerate our pre-event estimate of the probability of a given outcome occurring. To paraphrase Meir Statman, a finance professor at Santa Clara University: Hindsight bias may lead us to believe that even events that the “experts” failed to foresee were obvious—even inevitable.

The way to avoid this hindsight bias is to keep a diary of your forecasts. This might prevent you from remembering only your successes. It will also make you humble about your forecasting abilities, thus avoiding the mistake of overconfidence.

Maybe if those who panicked with the Trump win had kept a diary, they would have avoided panicked selling. Lastly, take the advice of columnist Jason Zweig: “Whenever some analyst seems to know what he’s talking about, remember that pigs will fly before he’ll ever release a full list of his past forecasts, including the bloopers.”

Enduring Myths
The election results also brought a second surprise related to one of the many investment myths that persist despite the fact that there’s no evidence to support belief in them. Among the most persistent myths are that the “sell in May” strategy really works, that past outperformance of actively managed funds is a reliably good predictor of future outperformance, and that rising (falling) interest rates are bad (good) for stocks.

The myth that rising rates are bad for stocks and falling rates are good for them exists despite the fact that, over the period 1927 through 2015, the annual correlation of the market beta premium and the term premium on bonds has been 0.007. The zero correlation simply means that sometimes rising (falling) interest rates are good for stocks and sometimes they’re bad for stocks.

Let’s examine what happened. The day of the election, the yield on the 10-year Treasury note had closed at 1.88%. Two days later, it had jumped all the way to 2.15%. Now imagine you had a crystal ball that would have allowed you to see what interest rates would be, but not stock prices. Believing in the myth, surely you would have been a seller. Yet the market had a strong rally.

 

This myth about the negative relationship between interest rates and stock prices is a result of investors falling for what economists call the “money illusion.” The belief that nominal interest rates should matter to stock valuations is based on the concept that bonds are competing instruments for stocks. But investors using metrics that compare bond yields to price-to-earnings (P/E) ratios to determine “fair value” are making an error.

By thinking of things in isolation, they fail to see the whole picture. In this case, as I mentioned, the belief is based on what is called the money illusion. The money illusion has great potential for causing investors to make mistakes, because one of the most popular indicators used to determine if the market is undervalued or overvalued is the Fed model.

In 1997, in his monetary policy report to Congress, then-Federal Reserve Chairman Alan Greenspan indicated that changes in the ratio of prices in the S&P 500 to consensus estimates of earnings during the coming 12 months have often been inversely related to changes in long-term Treasury yields.

Following this report, Edward Yardeni speculated the Fed was using a model to determine if the market was fairly valued (how attractive stocks were priced relative to bonds). The model, despite no acknowledgment from the Fed, became known as the Fed model.

The Fed Model And Its Problems
Since Yardeni first coined the phrase, the Fed model as a valuation tool has become “conventional wisdom.” Unfortunately, much of what serves as conventional investment wisdom is wrong. There are two major problems with the Fed model. The first is that the expected return of stocks isn’t determined by their relative value to bonds. The expected real return is governed by the current dividend yield plus the expected real growth in dividends. To get the estimated nominal return, you add estimated inflation.

This is a critical point that seems to be lost on many investors. The end result is that those who believe low interest rates justify a high valuation for stocks, without that high valuation ever impacting expected returns, are likely to be disappointed. When P/E ratios are high, expected returns are low, and vice versa, regardless of the level of interest rates.

The second problem with the Fed model is it fails to consider that inflation impacts corporate earnings differently than the return on fixed-income instruments. Over the long term, the nominal growth rate of corporate earnings has been in line with the nominal growth rate of the economy. Similarly, the real growth rate of corporate earnings has been in line with the real growth of the economy.

Thus, in the long term, the real growth rate of earnings is not impacted by inflation. On the other hand, the yield to maturity on a 10-year bond is a nominal return (to get the real return, you must subtract inflation).

Don’t Forget About Inflation
The error of comparing a number that isn’t impacted by inflation to one that is leads us to the money illusion. Let’s see why. To keep our example simple, we’ll assume that there’s no risk premium in the yield on nominal bonds for unexpected inflation and also that there’s no liquidity premium in the yield on Treasury inflation-protected securities (TIPS).

Let’s assume as well the real yield on 10-year TIPS is 2% (wouldn’t that be nice) and the expected long-term rate of inflation is 3%. Thus, the 10-year Treasury bond yield would be 5%, and a fair value for stocks would be at a P/E of 20.

 

Now, lower the 3% assumption for inflation to 2%. This would result in yields on the 10-year Treasury bond falling from 5% to 4%, causing the fair value P/E to rise to 25. But since inflation does not impact the real rate of return demanded by equity investors, it shouldn’t impact valuations.

In addition, as stated above, over the long term, there is a strong relationship between nominal earnings growth and inflation. In this case, the long-term expected inflation rate of 2% instead of 3% would be expected to lower the growth of nominal earnings by 1%, but have no impact on the growth of real earnings (the only kind that matters).

Because the real return on bonds is impacted by inflation, while real earnings growth is not, the Fed model measures a number that is impacted by inflation against a number that isn’t, causing the money illusion.

Getting ‘Real’ About Interest Rates
Now let’s consider what would happen if the real interest rate component of bond prices fell. The real rate is reflective of economic demand. So, it’s also reflective of the rate of growth of the real economy. If the real rate falls because of a slower economic growth rate, interest rates would fall, reflecting reduced demand.

Using our previous example, if the real rate on TIPS fell from 2% to 1%, it would have the same impact on nominal rates as a 1% drop in expected inflation, and thus the same impact on the fair value P/E ratio—causing fair value to rise.

This too, however, doesn’t make sense. A slower rate of real economic growth means a slower rate of real growth in corporate earnings. Thus, while competition from lower interest rates is reduced, future earnings will be as well.

Because corporate earnings have grown in line with nominal GNP growth, a 1% lower long-term growth rate in GNP would lead to 1% lower expected growth in corporate earnings. So the “benefit” of falling interest rates would be offset by the equivalent fall in future expected earnings.

The reverse would be true if a stronger economy caused a rise in real interest rates. The negative effect of a higher rate of interest would be offset by a faster expected growth in earnings. The bottom line is there is no reason to believe stock valuations should change if the real return demanded by investors hasn’t changed.

Conclusions
When AQR Capital’s Clifford Asness studied the period 1881 through 2001, he concluded the Fed model had no predictive power in terms of absolute stock returns. In other words, the conventional wisdom was wrong.

Asness also concluded that, over 10-year horizons, the P/E ratio does have strong forecasting powers. Thus, the lower the P/E ratio, the higher the expected returns to stocks, regardless of the level of interest rates, and vice versa.

There’s one final point to consider. A stronger economy, leading to higher real interest rates, should be expected to lead to a rise in corporate earnings. The stronger economy reduces the risks of equity investing. In turn, that could lead investors to accept a lower risk premium.

Thus, it’s possible that higher interest rates, if caused by a stronger economy and not higher inflation, could actually justify higher valuations for stocks. The Fed model, however, would suggest that higher interest rates indicate stocks are less attractive. And the reverse would be true if a weaker economy led to lower real interest rates.

Even smart investors make mistakes, usually out of ignorance. You, however, now have the tools to see through the money illusion.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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