Pim Poppe: Stock market valuation, interest rates and ALM
By Pim Poppe, Risk Management Professional at Probability & Partners
Stock market valuation has always been a matter of debate, with experts taking up various viewpoints for various reasons. Currently, the variety of viewpoints concerning valuation is getting even more noticeable.
My professional risk management colleagues and central bankers are getting a bit nervous when other people ask them for advice on how to get more exposure in the stock market, or, for that matter, on how to buy houses or enter Bitcoin. Some of them are wary, others are positive and fearless. Over the last weeks, we have observed some inflation and interest-rate-related jitters in the stock market. What does this say about stock market valuation and interest rates?
The viewpoint of Robert Shiller is especially noticeable in this respect. The professor and Nobel Laureate, who more the less coined the concept of irrational exuberance, is now writing about ‘Making Sense of Sky-High Stock Markets’. Back in 1996, Shiller introduced the CAPE ratio, an acronym for Cyclically Adjusted Price-to-Earnings ratio, which is also known as the Shiller P/E ratio.
This ratio has regularly been used by market practitioners in asset management. At the moment, the CAPE ratio is sky-high, and thus, the market looks expensive. However, according to Shiller this is no reason to worry. He explains the high stock market valuations as being the result of the low-interest rates. For this reason, he introduced a measure that also takes into account long interest rates, Excess Cape Yield or 'ECY'.
Curious about the market's valuation and the predicting power of the old CAPE and the new ECY, a group of Quantitative Risk Management Students from VU University1 has started rebuilding the CAPE and ECY bottom-up. They conducted research on S&P data for the period January 1975 - December 2020. To keep the reader from boredom, we skip the sections about data collection, indicator formulas, correction for inflation, and statistical methodology. We jump right to conclusions:
- Both CAPE and ECY-ratio are significant predictors of long-term total returns for equity.
- In recent years, ECY has been a better predictor than CAPE, which probably relates to the low-rate environment.
- CAPE-ratio has been significantly less reliable during the COVID-19 market-Cycle.
- Tactical asset allocation with ECY generated more added value in risk-return than with the CAPE.
- CAPE and ECY are currently in disagreement as never before. CAPE indicates that the S&P is now significantly overvalued. It is in its 92nd percentile. ECY suggests that S&P is still slightly undervalued. It is 35th percentile in expensiveness.
In 2021 this analysis will have profound economic relevance for pension funds and insurance companies. A substantial amount of pension funds will conduct their triennial ALM Study in 2021. As we all know, the data input largely determines the outcome of the ALM. Therefore, pension fund's directors will have to consider the long-term expected returns for equity and bond. Also, they should not hide behind their consultant, but challenge them and finally assume the assumptions as if they had been their own.
An institutional investor has four options when seeking to derive assumption for expected returns:
- Always use the same expected returns.
- Use history as a guide for the future.
- Take equity market valuation into account, using CAPE (for example) to decide about the expected return.
- Take interest rate-adjusted market valuation into account, using ECY (for example).
All these options are legitimate choices that are being used in Asset Allocation and ALM studies. They all have pros and cons and often the input is a mixture of these approaches. However, having a conceptual framework and some statistical backing of your preferences does make sense. The analysis of these three bright students might indeed be helpful. And finally, any pension fund director should be able to understand, explain, and substantiate his or her well-informed choices.
1Leo Spaans, Savannah Abdoelhafiezkhan, Marco Vitari
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