Prognosis and strategies for a market that isn't pricing risk properly. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary

There is a disturbing underlying trend in the market: risk is not being properly priced. Our five-year forecasts show that most asset indices are expected to earn very little over cash. If risk premiums on equity assets were to return to more normal levels, we would need a correction of about 15% to 20%. Our guess is that in 2006 investors will be myopic and not view low risk premiums as an immediate problem. As a result, the global equity market (in aggregate) will continue to reward investors on the margin for taking equity risk. There are few securities that are selling at anything that would be described as cheap valuations. “Put” options on the S&P 500 may represent one of the best values around. If investors are sensible, the market party will end before things became ugly. However, I don’t think that will happen in 2006. Party on!

Party pooper

Why do I think the party should end? It’s not because I subscribe to messianic forecasts of economic doom. The economy isn't going great guns, but it's doing just fine. This growth scenario has the distinct advantage that it is neither too hot nor too cold. As a result, inflation, particularly wage inflation, should stay under control.

If the economy isn’t a real problem, is there an issue with stock market valuations and earnings? In fact, neither current earnings trends nor current valuations look bad. For next year, analysts are forecasting that earnings will grow by 13%. While this may be too optimistic, a double-digit number is reasonable and would still be greeted warmly by Wall Street. Companies have managed to produce consistent positive earnings surprises by managing their investment in capital very carefully. I don’t think this will change next year, barring some traumatic event.

|image1|

Likewise, valuations on the markets aren’t horrible: the P/E ratio on the market was about 17 times trailing earnings at year-end 2005. This is somewhat high, but not outrageously so. In fact, the P/E for the market tends to hang out somewhere between 15 times and 17 times earnings. Historically, when the P/E ratio on the market (based on trailing earnings) has been between 15.6 and 18.2, the market has earned, on average, 10.5% over the subsequent twelve months.

As we look around the world, we can make similar observations about the other equity markets. Valuations are on the high side but they are not unreasonable. Earnings will probably come in better than expected.

So why am I feeling uneasy?

Risk Premium

There’s a bothersome theme running though the market right now: investors seem to be getting paid very little to take risk.

The Wall Street Journal recently ran an interesting series on the global savings glut. This may seem counter-intuitive to many Americans because our low savings rate. Two things offset this though. First, the official U.S. savings rate understates true savings levels here. Second, and more important, the world’s capital markets are closely integrated. An excess of savings in one country gets transmitted very quickly across borders to find competitive rates of return, just as more water in the ocean leads to higher tides on both shores of an ocean. The world has money to save, and the net effect of excessive savings is the bidding up of asset prices and decreasing rates of prospective return.

This is evident when we look at the fixed income markets. The most noticeable phenomenon in the fixed income market is that the difference between the yields on cash or short-term investments is almost equal to the yields on longer-term maturity bonds. The yield on a three-month Treasury bill is 4.0% versus 4.6% for a thirty-year bond. This means you are only getting paid about 0.6% for taking all of the risk inherent in a longer-maturity security.

The biggest fear for bond investors is inflation; here the news is, at best, mediocre. As demonstrated by the following chart, which shows real yield on bonds, investors are being paid a relatively small premium over inflation. Real yields, the premiums that investors earned over inflation in the Volker-Greenspan period, averaged about 3%. These days, the real yield on ordinary Treasury bonds and Treasury Inflation Protected Securities (or TIPS) are well below their historical premiums.

|image2|

The markets aren’t paying much for credit risk either. The credit spread, the difference between the yield on high quality corporate debt and Treasury bonds, is also very low. Even more disturbing, yield spreads are quite low on lower credit fixed income, including high-yield and emerging-market debt.

As long as these spreads stay the same, investors will continue to earn premiums over higher quality instruments. But what happens when investors wake up and want “normal” risk premiums on the credit risk and maturity risk that they are taking?

Equities too

Figuring out the risk premium paid to investors in the equity market is a little more difficult than in the fixed income market, because the payoff for holding an equity security is not a fixed “amount.”

The ratio of prices to earnings is the most commonly recognized measure of the market’s risk premium. As we mentioned earlier, this would seem to tell us that stocks are somewhat expensive based on trailing earnings and historical trends. There is a somewhat myopic view, however, because earnings are very cyclical. We go through periods when profit margins are very low (such as right after a recession) and times when profits are very high. Right now, earnings are about 15% above the longer-term normal “trend line” levels. |image3| |image4| The picture of the market’s valuation changes quite a bit when we calculate the P/E ratio not on the 2005 year-end earnings estimate of $76, but based upon a normal “trend line” level of $64. Now we are not looking at a market trading at 16.7 times earnings, but a market trading at a P/E of 19.5 times earnings. From this perspective, the market is paying a lot for relatively little in the way of stock market earnings.

|image5|

Let’s try to estimate stock-market returns assuming that the market values equities not on an inflated level of earnings but on normal earnings over a five-year period. The return to equity markets comes in the form of dividend yield and capital appreciation. Dividend yield is fairly easy to estimate. Capital appreciation comes from earnings growth and revaluation changes (or the price investors are willing to pay for those earnings). We expect dividend yield, including share buybacks, to produce an annual rate of return of 2.6% per annum.

As we indicated, the bad news comes from earnings growth. While we anticipate that earnings growth will be fairly strong over the next year or two, we expect that over a five-year period it will amount to only about 3.8% per annum, as earnings trend from very high profit margins down to more normal margins.

The final component to stock returns – revaluation – is not likely to help much, given that stocks are trading at slightly above normal P/E ratios. Adding up the returns from dividends, earnings growth, and revaluation produces a total rate of return over five years of only 5%.

|image6|

We have done the same sort of exercise with all of the other major equity asset classes, including small-cap and international stocks. In addition, we have made similar five-year estimates for U.S. bonds, Global Bonds, and TIPS.

The results, excluding security selection, are stunningly dull, and it would appear that equity indices (or benchmarks) won’t return much in excess of cash. Active management, or security selection, offers the best hope for earning a premium over cash and bond returns.

(Click here for the second part of Review and outlook: Market risk miss-priced.)

.

Weekly Review & Outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.