We’re always told that markets are forward-looking, and that they’re all about expectations.
That raises a bit of a paradox.
In the long run, corporate profit margins are “mean-reverting”. In other words, when margins are high relative to history, the most likely future outcome is that they will go down, not up.
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Now, you can debate the whole concept of mean reversion – in recent history, margins have stayed high. We can discuss various reasons for that, but even back when margins were reliably mean-reverting, markets did not behave as you’d expect them to.
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That’s according to a model put together by Jeremy Grantham and Ben Inker of US asset manager GMO in the late 1990s, when they were trying to work out what on earth had been going on during the dotcom bubble of the late 1990s.
Grantham and Inker’s goal was to work out what factors actually make investors willing to pay high price/earnings multiples for shares?
What they discovered is that share prices are not actually based on future prospects. Instead they’re based on current conditions being extrapolated into the future. And the conditions that matter most are those that make investors feel comfortable (for which you can probably substitute the term “complacent”).
What makes investors feel relaxed?
The question then is: what makes investors feel so happy about the future that they are willing to cough up more for a given pound or dollar of earnings?
There are two main factors. One is high profit margins; in other words, when margins are high, investors expect them to stay high, and they will pay up for the privilege.
The second is particularly pertinent today: it’s low and stable inflation. So ideally inflation around the 2% mark.
GDP growth is a third, but all that really matters there is that it’s relatively stable.
In other words, according to the model, investors value stocks based on how pleasant the weather is today, as opposed to on any expectation of how the weather will be tomorrow.
This makes sense given what we see happening in markets all the time. And according to Grantham and Inker, the model tracks “real life” p/es very well, and particularly at extremes.
Back in 2017, when Grantham revisited the model, he made the point that “investors love high margins and like stable growth even if it’s modest, and hate inflation”. In 2017, it seemed that these things were going to persist, and that as a result, high p/e ratios should persist too.
“If we expect a market crash, we should also expect to have a crash in margins (as we did in 2008-09) or a truly dramatic rise in sustained inflation (as we did in 1979-81) or some powerful combination. All of which is possible of course, but I think improbable, at least in the near term.”
Grantham was right at the time. And more importantly for us now, it seems pretty clear that he was right about a market crash requiring falling margins or a surge in inflation. In 2020, the market crashed briefly as it looked like profits would be wiped out and bankruptcies would soar due to the global economy shutting down. Then central banks printed money and governments used it to fund furlough schemes, and all was fine again.
Starting in 2021 and lasting into 2022, we’ve seen another crash as inflation has become the bugbear, making investors distinctly uncomfortable.
So the question is: what does the “comfort model” show now?
Investors are still too comfortable
Matt Kadnar at GMO provides an update in which he makes the point that even though the S&P 500 has fallen sharply this year, it still trades on a “fairly lofty p/e of about 30”. The comfort model, by contrast, suggests that the p/e should be closer to 19.
As a result, despite the slide in stocks, the disparity between actual valuations and model valuations is as high as it was in the dotcom bubble of the late 1990s.
What does this suggest? Most obviously, it suggests that stocks have further to fall. Less obvious, but worth remembering, is that it’s always possible to close this sort of gap in other ways. The price/earnings ratio has two parts; if you want to reduce its value, the price can fall, but a static price and rising earnings will also reduce that ratio. Rising earnings at this point seems unlikely though.
How about another more positive way to close the gap – that is, a drop in and stabilisation of inflation? I think this is what markets are hoping for right now and I suspect that any concrete sign of stability will be greeted with a surge in asset prices generally. But it’s not necessarily something I would bet the house on.
There’s an old saying in markets that bull markets go up the stairs, while bear markets take the lift. In other words, markets trend higher relatively slowly, but when they turn, it’s a rapid ride. There’s truth to this but it obscures the fact that nothing – not even bear markets – moves in a straight line.
By all means nibble on the stocks on your watchlist if they are at levels you’ve already researched and concluded as being good opportunities. But I’d still tread cautiously.
