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Is the equity market a sober reflection of companies’ future profitability, or is it crazy? It is crazy.
Today, the S&P 500 is more than 50 per cent above its average level in 2011. In what sense is this justified? Bond yields are unchanged. The world is no more predictable. Long-term profitability has not risen by 50 per cent. And to cite quantitative easing is like saying that a roof was torn off because of a high wind, rather than that it was not properly nailed down.
Nobel laureate Robert Shiller has given scientific justification to the basic intuition that equities are excessively volatile when compared with their fundamentals. After centuries of equity craziness we wearily accept it, like the weather.
There is a major problem with the usual explanations – crowd psychology, unaccountable professionals and so forth. The work of Prof Shiller et al suggests excess volatility is not easily identifiable in the US Treasury bond market, in which not even QE has triggered what equity people would call a bubble. And yet, it has the same dramatis personae as its equity counterpart. The problem must lie with equities themselves, rather than with those who own and trade them.
Both equities and bonds promise regular future payments to the holder, and in the short term, contractual payments on bonds (interest coupons, principal) are much more predictable than discretionary payments on equities (dividends, buybacks). But in the longer term, and taking all equities together, the real value of equity payments is more predictable because they are tethered to overall economic growth, while bond payments are at the mercy of price inflation.
Equity dividends are astonishingly resilient and stable over long periods. They enabled German shares to maintain their real value between 1900 and 1956 despite ruinous inflation in the 1920s and national annihilation in the 1940s (German government bonds did not even make it through the 1920s).
So what makes bonds seem dull and equities exciting? First, because economies are unstable in the short term, the same is true of earnings and dividends/buybacks. Second, individual companies have wildly different prospects. Third, by having different maturities, the bond market has an “inductive anchor chain of reference”: bonds are priced with reference to others of shorter maturity. Fourth, equities, unlike most bonds, are perpetual, and when yields are low, simple maths shows that price fluctuations for a given yield shift are vastly magnified.
Faced with a myriad discretionary dividend streams that are volatile in the short run, and without an anchor chain, all but the most patient equity investors give up on the longer term. They fall back on forecasting 18 months ahead at most, speculating on events in that timeframe or simply on momentum. In comes the craziness.
This is punishingly expensive. The market fears its own craziness and demands a massive risk premium over short rates, 4-6 per cent a year, versus 1 per cent a year for government bonds, whose income stream has comparable long-term predictability. This translates into higher investment hurdle rates, an excessive profit share and lower economic growth.
For all our sakes, equities need to be saved from fearing themselves.
One possible approach is for companies to issue “short and long certificates” (SCs and LCs) in lieu of ordinary shares, the former giving the right to the next 10 years of dividends, the latter the right to the rest. Every year they would roll over, the SC receiving that year’s dividend and paying the LC holder the market value of a 10-year dividend future.
The SC market would be driven by 10-year dividend forecasts, and would be splendidly dull. Investors making multiyear forecasts would not be dealing in fantasy: they expect company bosses to do the same when making investment decisions. Thus, a flood of new visibility on corporate prospects, an instrument which connects bosses with investors on a sensible timescale, and which can be used to remunerate those bosses.
The worry is that all the craziness we see today in ordinary shares would reappear in LCs. I hope not. For one thing, their annual income would be the 10-year future, much more stable than the current year dividend, the SCs having “digested” companies’ short-term unpredictability, and acting as the inductive anchor chain.
Meanwhile, every company has a forecast horizon beyond which it makes no sense to prognosticate. By definition, companies with the same forecast horizon should carry the same valuation at that horizon. Ten years is a reasonable guess at the horizon’s average distance. There should therefore be a strong tendency for all LC values to converge to the same multiple of the 10-year dividend forecast.
Miko Giedroyc is a retired equity strategist and research director
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