Pro-cyclical and pro-secular
You have probably heard people bandy about the term pro-cyclical as it has become a key concept for economists as we enter a downturn. The crux of pro-cyclicality is that some things rise with an upswing, but fall with downswings — exacerbating swings in the business cycle. As I will explain, much of this is due to psychology.
A perfect example of such a pro-cyclical data point is new home sales. For some strange reason, house builders tend to build many more houses as the business cycle hits its zenith, only to see be forced to cut back doubly as the economy slows and an inventory overhang results. This double cutback effect makes a downturn more pronounced.
The opposite of pro-cyclicality is anti-cyclicality — where the data show a decrease as the economy rises, but an increase as the economy falls. Perversely, it seems that bank charge-offs fall into that category, with banks actually charging off the least at the peak in the cycle (see UK bubble for a chart of this in the UK). Obviously, this also exacerbates downturns as banks must increase charge-offs doubly in order to get back to an average cycle charge-off level and to account for the downturn as well.
To my mind, a core of these business cycle errors is the recency effect. Wikipedia describes the effect like this:
The recency effect, in psychology, is a cognitive bias that results from disproportionate salience of recent stimuli or observations. People tend to recall items that were at the end on a list rather than items that were in the middle on a list. For example, if a driver sees an equal total number of red cars as blue cars during a long journey, but there happens to be a glut of red cars at the end of the journey, he or she is likely to conclude that there were more red cars than blue cars throughout the drive.
Basically, business people become accustomed to the economic environment of an upswing and overproduce in the case of house builders or underallocate for loan losses in the case of banks. This is one reason recessions tend to be severe.
But the same effect is at play in investing. Except here I consider it a pro-secular trend. Price-earnings (P/E) ratios actually increase as a secular bull market gains strength. They decrease as a secular bear market lengthens. In fact, 80% of the gain in the Bull Market from 1982-1999 came from increasing P/E ratios and not from an increase in the underlying earnings power of the stocks.
Stocks are currently [as of Aug. 2004] at a P/E ratio of 22, based upon 12 month trailing earnings. What, [Jeremy] Grantham asks, would be the total stock market return over the next seven years if P/E ratios revert to the mean of 16?
Remember my contention that stock market valuations have always proven to be a lean, mean reversion machine. This can be good when valuations are to low, but it is painful for future returns when valuations are too high or above trend.
There are four components to the growth of stock market returns. Two of them are real sales per share growth and dividend yields. Grantham expects real sales to grow at about 2.9%, which he admits is optimistic.
Sound too low? Long term real sales growth per share has been around 1.8%. Even in the powerhouse 90’s, real (inflation adjusted) sales per share growth was a very average 1.9%. Compare this with my study which shows earnings growth for the ten years beginning 1993 was a meager 1% per year or 4% if you included
Grantham, optimist that he is, assumes that dividend yields for the next 7 years
will grow to 2.3%, up from the historically low 1.7% at which they are today.
Combine these two returns and you get 5.2% growth over the next 7 years (again
in real terms).
But then it gets ugly. The major component of stock markets returns is either
the increase or decrease of P/E valuations. If we see the P/E ratio return to
“fair value” or drop from 22 to 16, that reduces returns by a negative -4.5% per
year over the next seven years. Again, remember that 80% of the growth in the
stock market from 1982 to 1999 had nothing to do with earnings growth or
inflation. It was due entirely to an expansion of the P/E ratio, from single
digits in 1982 to around 32 in early 2000. What provided the wind in the sails
in the boom will be the drag of a heavy anchor as valuations revert to the mean.
Profit margins are the final component. Today they are high, almost off the top
of the charts, at 7%. Historically, profit margins run around 4.9%. Grantham
(again, perhaps optimistically) thinks they will only fall to 6%.
Why would profit margins fall? Because as Grantham jokes, “If profit margins do
not mean revert, capitalism is broken.” What does he mean by that?
Any time margins get too high for a business, some competitor looks at them and
says, “I can do that cheaper and will be glad to take smaller margins.”
Competition serves to hold down prices and profit margins. Conversely, when
profit margins are too thin, businesses tend to fail thus opening the way for
the survivors to charge more.
This ebb and flow is part of the business cycle that began shortly after the
Medes started trading with the Persians. But if margins begin to erode, their
contribution to stock market growth will become negative. Grantham suggests that the result will be a negative real return of -2.1% per year over the next seven
Adding all four components together, and you get a compound real annual return
over the next seven years of a negative -1.7% a year. Add in expected inflation
and you still get less than 1% annual returns. Not a thrilling ride for
investors expecting 10%.
–A Lean, Mean Reversion Machine – John Mauldin’s Weekly E-Letter, 6 Aug 2004
So, when we see stocks falling and the P/E ratio of the market overall contracting, we should remember it may be because investor has changed. The P/E ratio of American stocks is still not anywhere near the single-digit secular bear market lows. This is one reason why I do not anticipate huge gains by the overall market over the medium-term any more than Jeremy Grantham does.
It is investors’ struggle to understand this that drives stocks in bear markets to deep value levels. And we are clearly in a secular bear market.