Equities: Reassuringly expensive?

The beer drinkers among you will immediately appreciate that I have stolen my title from a well known slogan for Stella Artois.

As a guy that has worked in the asset management industry for over 27 years, and been immersed in economics on an almost daily basis, I can safely say that I don't understand the concept of a beer being reassuringly expensive. Marginal utility theory stipulates that we should be running around trying to maximise our satisfaction from a given budget, and overspending on hyped-up beer just doesn't make sense to me.

For any of you that grew up in the 1980s, I was never an Amstrad guy (too cheap and nasty - sorry, Sir Alan) but I would buy Sanyo Electronics rather than Sony. And, for similar reasons, I like Samsung and LG today...quality products at reasonable prices.

Of course, we cannot apply the same logic to the purchase of equities because investing is more of an emotive issue. I will spare you the behavioural finance principles or the hackneyed quotes and simply say that I'm more scared of large losses than I am excited by the prospect of winning big - usually!

But here is my conundrum...I don't have adequate pension provision. I'm sure I'm not the only one in this situation who belongs in the era between baby boomers and millenials. Baby boomers climbed on the property ladder cheaply and many have gold-plated pensions, but they lived through hardships way beyond mine in their formative years.

Similarly, millennials had it easy from birth but will encounter much greater difficulties in achieving the aspirations that sociological norms heap upon us, such as buying houses and showing their children that human genius will always ensure each generation enjoys a higher standard of living than its predecessor.

Of course equities are expensive...

To be honest, I get really bored when I read media pieces saying that, according to the Shiller P/E ratio (I recommend a visit to www.irrationalexuberance.com - their data is fascinating), equities are more expensive than they ever have been, with the exception of 1929 and 2000.

No sh*t, Sherlock!

Just take a look at how low the risk-free rate still is almost exactly two years into the latest Fed tightening cycle and ask yourself how long such cycles last. We could literally be decades away from 5% interest rates.

The long-run average of the Shiller P/E (seasonally-adjusted P/E ratio) is 14 and if you look at the charts and draw a horizontal line, you will see that equity valuations dissect this level more than any other on their relentless journey from seriously undervalued to the opposite extreme and back again (fair value is always so fleeting that it might as well be a mirage - animal spirits will always ensure this).

But, the reciprocal of 14 is a smidgeon over 7. And the reciprocal of the P/E constitutes the earnings yield. So, this also averages 7 in the long run. There is a good reason for this - over the course of most cycles 7% is a fair enough price to pay for entrepreneurial capital and a suitable yield for accepting the risk in order to participate in what hopefully transpires to be a successful venture.

Now, I'm sure everybody has heard of the equity risk premium (ERP). This is the return that you should receive over and above the risk-free rate as compensation for the risk associated with holding equities. If you google it, you will find answers that the average is somewhere north of 3.

Now, I have to say that I don't really buy that because it is biased way too high by the extra-ordinary 18-year bull run we had in equities between 1982 and 2000. You simply wouldn't, in theory at least, earn such a high reward for holding equities frequently otherwise everybody would be borrowing money (leverage) to invest. Which, of course, is exactly what happened in the late 1920s and the late 1990s - with almost predictable consequences.

But, enough of that, let's revert to our starting point. A P/E of 14 is perfectly reasonable when interest rates are normal. But when interest rates are high (late 70s/early 80s) you would expect it to be lower than that. In fact, at the start of the aforementioned great bull market in 1982 it dropped close to 5.

The obvious counterbalance to that is that when interest rates are unprecedentedly low, you should expect a spectacular overshoot to the upside - which is what we've got now. But the big differences are that we didn't have exceptionally low interest rates in either 1929 or 2000 and people are not now borrowing money left, right and centre in expectation of earning higher returns in stocks.

In fact, the current bull market is often referred to as 'unloved' because the average person on the street has not even participated in it, let alone borrowed money (to take advantage of the low cost of capital) to invest in equities.

Cash is not king!

My pension fund hasn't been in cash for long.

It was in Japanese equities for a few years and did spectacularly well. Then I switched into Continental Europe to capitalise on the uncertainty surrounding the French election - another good move...decent gains from Euro appreciation as well as rising equity prices.

However, I switched into cash as I wanted to hang onto my gains through the traditional period of light trading volumes in the summer, when any moves to the downside can be amplified by a shortage of dip buyers.

This proved an unnecessary safety measure, but the worst of it is that I cannot now find the courage to put risk back on. The media is telling me that equities are in a bubble and plain old common sense is telling me that a bull market that has gone on for nearly nine years has to end in tears...

...but perhaps not yet!

Reassuringly expensive?

Equities are not reassuringly expensive or my pension fund would not be in cash.

But 'rationally expensive' certainly seems fair.

I listened to a fascinating podcast with a former close colleague and mentor, Trevor Greetham, this week. I presented his 'investment clock' to audiences on his behalf many times. As Trevor intimates, a lot of people are aware of the valuable concept of the investment clock but few can tell what time it is.

If midnight is the hour when equities turn into pumpkins and bulls turn into mice, Trevor believes we're in the early evening, according to this analogy.

If I can't shake off my cognitive biases, I'm going to be working well into my 70s!!

?Please note these ramblings are entirely my own and I am not posting them in any official capacity. But, if you have enjoyed reading this, please 'like' and/or comment below