No Lost Decade for S&P 500?!

I came across this article in Bloomberg on how a equally weighted index of S&P 500 stocks (as opposed to market cap weighted index which is what the actual S&P 500 is) would have shown that the decade of 2001-10 was not a lost decade and that this equally weighted index had gone up by 66% (March 24, 2000 to Dec. 2, 2011 to be precise). Along the way, several other egregious statements have also been made in the article.

First of all, it might not have had a lost decade on this basis. But, it had a ‘lost 11 years’. How about that? If you have access to Bloomberg, just type SPW index GP M and you will see the movement of this equally weighted index. On Feb. 27, 1998, the index crossed 1000 and by Jan. 3o, 2009, the index was at 1000 again. So, a near 11-year period of no price appreciation in nominal terms. In real terms, a substantial negative performance.

Cliff Asness had a blunt and correct response to this news article:

Gains in the equal-weighted index reflect appreciation in its smaller companies and stocks with lower valuations over the past decade, according to Asness, who helps oversee $38.8 billion as founder and president of the AQR hedge fund in Greenwich, Connecticut. Since most investors didn’t anticipate that, they weren’t spared the lost decade, he said.

“Sorry, I’m not sure it means more than small-cap and cheap stocks had a good decade,” Asness wrote in an e-mail. “If you add us all up, we add up to cap-weighted, not equal- weighted indexes.”

Here comes another gem:

Cisco (CSCO) in San Jose, California, trailed the S&P 500 in eight out of the last 11 years as the market value of the world’s biggest maker of networking equipment fell 82 percent to $99.7 billion. The stock is down 8.3 percent this year, even after posting earnings that beat analysts’ estimates for at least the 27th straight quarter.

Now, since when does beating the analysts’ estimates become the yardstick for stocks to perform well. None of the stock valuation models show that the price is a function of the excess EPS over analysts’ estimates. Second, we all know how the whole game of setting expectations and beating them is played. Yet, to mention that as a factor is puzzling, to say the least.

CISCO was a darling stock of investors in the IT-Bubble era. It was probably priced to deliver earnings growth of  20-30% per annum for the next 10-15 years. Investors, in their frenzy, never pay attention to the historical fact that almost no stock maintains its high growth performance in earnings for more than 5 years. Competition ensures that it does not happen. That is why it is important to keep barriers to entry low in any industry so that near-monopoly or monopoly profits are not earned into eternity.

If one looked at the CISCO EPS (and I am sure that the company had done its own share of ‘Share Buybacks’ to boost EPS) performance over the years, it has been flat at worst or it shows tepid growth at best. No surprises, therefore, that the stock has gone nowhere, given that it had priced in a much higher earnings growth as it entered the new millennium.

It appears that the thinly-veiled purpose of the article is to entice investors back into the stock market since, even after all the monetary stimulus, investors have been pulling money out of stock mutual funds more often and in much greater numbers than they have been putting them in. Check out for these weekly and monthly updates on flows into international and domestic equity mutual funds by US investors.

That brings me to another point and that is the latest quarterly investor news letter from Jeremy Grantham. I look forward to it every three months. You can find it here.

He makes an interesting point:

The two (out of three) most important drivers were profit margins and inflation. Well, today we have (remarkably, even weirdly) record profit margins. And by historical standards, stable and low inflation.

In a sense, he answers the frustration of those who cannot understand why the S&P 500 is trading near 1260 points. Markets focus on earnings (why it does not focus on dividends is a mystery) and on the low inflation rate. To a degree, one can understand the focus on earnings – that is the numerator in the the Stock price model. The denominator – especially for a long duration asset like stocks- cannot be solely a function of short-term inflation. It has to incorporate a lot more information that reflects the true risk of sustaining those earnings well into the future.

In other words, the discount rate should not only include inflation and monetary policy outlook near-term but budget deficit outlook and other societal and economic risks. That today’s markets do not is a failure – the failure of cost of capital to reflect all the relevant risks. That is partly due to the excessively low benchmark rate set by the Federal Reserve since 1997-98 with a brief episodic exception between 1999 and 2000.

One does not know when that error will be corrected. But, when it does, valuations of stocks will take it on their chin.

This post originally appeared at The Gold Standard and is posted with permission.

3 Responses to "No Lost Decade for S&P 500?!"

  1. shiv139   December 16, 2011 at 10:48 am

    P divided by E gives you a multiple. But it tells you nothing about what that number represents.
    If you look at things in the context of intrinsic value, the multiple reflects investor expectations as 1 *(1+G)/(R-G)*(1-P); where G is the long term nominal earnings growth expectation, R is the investor total return expectation and P is the payout ratio expectation. This reflects the PV of future cash flows retained by the company.
    Or if you look at things in the context of fair value, the multiple reflects investor expectations as 1*P*(1+G)/(R-G); where G is the long term nominal earnings growth expectation, R is the investor total return expectation and P is the payout ratio expectation. This reflects the PV of future cash flows distributed by the company.
    A number like the PE is meaningless unless you try and figure what it is saying; then sometimes you can spot the lie.

  2. shiv139   December 16, 2011 at 10:53 am

    You can break G into RE*(1+i) which is real earnings growth plus inflation.
    You can break R into a risk free real rate, inflation, and a risk premium (growth risk + equity risk premium).
    And for P, you need to look at total value returned to shareholders through both dividends and buybacks.