While heuristics are critical to the fluidity of our daily existence, they can be damaging to investment decisions. Our subconscious decision-making structures are riddled with sensory misconceptions, irrational anomalies, and biases.
Anchoring – precipitating the immediate past
One such predisposition is anchoring – our brains’ tendency when deciding, to place undue emphasis on past events (often the immediate past) rather than on other evidence or opposing facts.
Current anchoring risks
We believe anchoring biases exist in the markets’ perception of how the Fed will respond to inflation, on corporate profitability and what an appropriate market rating is. To understand this, we need to explore the world we are accustomed to, with regards to inflation, interest rates, earnings growth, multiples, and investment returns.
Bull markets – the norm since the early 1980’s
There have been two great S&P bull markets during our time, the first started in July 1982, which ended in the dotcom bust in March 2000 and the second, commenced in February 2009 and ended in December 2021.
Historical returns and P/E’s
Dividends excluded, for both periods the S&P produced nominal annualized returns of 15.7%, the long-term average since 1956 is 8.85%. After a period of tough economic conditions and depressed security prices, the first of these bull markets launched off a P/E of only seven times and the P/E averaged about nineteen times through the period.
The second started after earnings expectations rose post the GFC (Great Financial Crisis) driven by fiscal and monetary stimulus – the P/E multiple averaged 22.5x over this favourable market. The long-term average P/E of the S&P since 1956 has been 18.2x.
Interest rates since 1954
From 1954 to 1982, US interest rates rose, despite six mini reducing cycles through this period. Rates moved from below 0.5% in the early 1950’s to almost 20% in 1981. Conversely, despite spicey mini rising cycles, the overall trend was down from 1982 onwards with rates bottoming out at 0% in 2020. The present Fed funds rate is 2.25% – 2.5%.
Chart 1: Federal Funds Effective Rate
Source: US Federal Reserve (Date: September 2022)
Inflation has averaged a little over 4% since 1960. In 1966 it was below 3%, climbed above 6% in 1969 before settling back below 3%, but an oil crisis and aggressive post-Vietnam war fiscal stimulus in the 1970’s led to two inflation spikes, it exceeded 12% in 1975 and approached 15% in 1981.
The Fed of the early 1970’s operated initially in a similar fashion to what it is now – tepid increases with dovish retreats. Paul Volcker, in control from August 1979, changed tack, he called emergency interest rate meetings raising rates to 20% off a base of 11% in 1979.
The price environment changed in 1983 – despite a brief inflationary period from 1989 to 1992, where annual price increases reached 6% and again momentarily in 2008, for the past 30 years, inflation has averaged an insipid 2.8%.
With deflation occurring during the GFC (2009), central banks have worked furiously to keep price momentum positive, yet inflation reached another bottom of 0% in June 2020, and it is off this low that annual price changes soared, hitting 9% in the US in June of this year.
Earnings have grown on the S&P by 6.5% compound since 1955. The 1982 to 2000 bull market enjoyed above average earnings growth of 7.6% whereas rampant profit growth of 10.1% between 2009 to 2021 fuelled the last secular bull market.
The contemporary investor
So, an investor that has been at it since the early 1980’s has experienced low inflation, reducing interest rates, above average earnings growth, and rising P/E multiples, all of which culminated into exceptional returns, well above historical norms.
Never has the market looked so disconnected from its own history. We point to three examples.
In the attached graph the earnings yield (blue) on the S&P, has traditionally operated above inflation – giving investors positive real returns – this is no longer the case!
Chart 2: S&P 500 earnings yield vs US inflation
Source: Iress, Northstar (Date: September 2022)
The second aberration relates to the Fed funds rate against inflation, not in 40 years has the Fed been so far behind the inflation curve. Having engineered negative real rates in 2009 to stave off deflation, that 10-year experiment has worked so well that inflation is now rampant. Past heady inflation cycles have required an aggressive Fed.
Chart 3: Effective Federal Funds Rate vs US inflation
Source: Iress, Northstar (Date: September 2022)
Third is profitability – the last five years of earnings growth on the S&P has annualised 24.6% – this is top 10% percentile of earnings growth history. Following such a performance, 3-year annualized EPS growth is usually negative, yet market consensus is for high single digit growth.
Whilst market opportunities do exist, we believe heuristics, particularly anchoring is mispricing certain asset classes and in particular, specific securities. It takes tectonic market shifts to adjust perceptual biases and thus create new learnings – unfortunately, this will inevitably happen!