Kevin Coldiron of BGI reviews some of the literature of note on investment topics
Totally Unsustainable
Lombard Street Research Monthly Economic Review 114, December 1998
Was last autumn’s US credit crunch nothing of the kind? Companies may have struggled to borrow from the bond markets, but banks filled the breach readily - expanding loans at an annual rate of almost 30% in October alone. This paper makes the case that excess credit creation has been the main driver of the boom in US share prices. As the title suggests, the authors believe the cycle will eventually shift into reverse. Why should this happen? The appetite of US consumers for foreign goods and foreign investors for US securities has led to unsustainable trade and current account deficits. To stabilise the situation the US economy must slow significantly. The authors believe this cannot happen as long as consumers’ wealth - and hence their ability to keep spending - continues to be bolstered by an over-valued stock market.
Valuation Ratios and the Long-Run Stock Market Outlook
John Campbell and Robert Shiller, The Journal of Portfolio Management, Winter 1998, pp.11-26.
For over a century dividend yields and P/E ratios have reliably forecast long-run movements in US stock prices. These measures are at historically extreme levels, suggesting the outlook for US equities is unusually bearish. These sentences could have been written at the beginning of 1998, 1997 and probably even 1996. The fate of practitioners acting on this analysis has been, well, unpleasant. The market marches upward, voices of reason are less and less welcome. It’s probably appropriate then that two well-known financial academics - presumably possessed of rational expectations and long time horizons - remind us nothing has changed. It examines historical evidence dating from 1872, concluding that both dividend yields and P/Es help forecast longer-term movements in inflation-adjusted stock prices.
The Good News and Bad News about Long-Run Stock Market Returns
Donald Robertson and Stephen Wright, Faculty of Economics and Politics, University of Cambridge
http://papers.ssrn.com/sol3/paper.taf?ABSTRACT_ID=138170
Another look at the ability of fundamental valuation ratios to forecast long-term US stock returns. The valuation tool is Tobin’s q - the ratio of current firm value to net replacement cost of firm assets. As q rises the returns on existing capital differ from those on new capital. Theoretically, existing equities become more expensive making it more attractive to build rather than buy.
Investors influenced by this situation eventually drive the current firm values lower and q’s fair value is restored. The authors first investigate the extent to which q itself actually follows this mean-reverting pattern.
They then examine if movements in q can be used to predict stock prices.
The good news for investors is that the answer - according to this paper - is yes. Tobin’s q can help predict stock prices and can therefore be used to reduce long-term investment uncertainty. No prizes for guessing the bad news. Current levels of q suggest a real chance that inflation-adjusted stock returns will be negative in the coming years. Indeed gloomy is a more accurate description - the authors’ model suggests a 90% chance of negative returns over the next 10 years, improving only to 50/50 over 30 years.
Kevin Coldiron is head of European research at Barclays Global Investors in London
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