Wednesday, June 12, 2013

Looking At Equity Fundamentals

Gavyn Davies of the Financial Times was out yesterday with an excellent piece on the equity markets.

Many analysts have commented on the apparent disconnect between relatively weak economic growth and the recent strong performance of the equity markets. 

These same analysts generally cite the aggressive intervention of the Federal Reserve in the bond markets as one of the primary reasons that interest rates have remained low, and stocks have benefited as well.

Davies agrees with this to a point, but notes that the Fed can only influence the federal funds rate.  Market participants collectively determine the equity risk premium, which remains relatively high:

The appropriate discount rate {for future corporate earnings} is the risk-free (real) bond yield plus the equity risk premium (ERP).  The Fed acts on the former, while the market determines the latter.  In recent years, the Fed has reduced the bond yield but the market has, simultaneously, required a higher ERP, so the overall discount rate on equities has remained broadly unchanged.  As I have argued before, any rise in the bond yield as {quantitative easing} ends may be offset by a fall in the ERP, leaving the valuation of equities protected as bond returns become negative. We have seen a minuscule version of this playing out in recent weeks, for what it is worth.

Davies goes on to discuss another one of the favorite bear camp arguments:  namely, with corporate profit margins are unsustainably high.  As the economy improves, bears argue, worker share of revenues will almost surely start to rise, dragging corporate profitability lower,

Maybe.  But Davies points out that labor's share of corporate revenues has been steadily declining for three decades. If this changes, corporate profitability could be hit hard, but the forces that have caused little or no growth in wages (technology, globalization and an erosion of labor bargaining power) show few signs of reversing.

I continue to think that the markets are vulnerable to a correction, but so far my pessimism has not panned out.  Perhaps I am underestimating the degree to which so many investors - individual and institutional - are underweight stocks, and are using any pullback as an opportunity to add to positions.