How Do Valuations Impact Stock Markets?

The best information we can ever provide investors is the mechanics of how we think about macro conditions over time rather than what we think about them at any particular time. Consistent with this idea, we present our Macro Mechanics, a series of notes that describe our mechanical understanding of how the economy and markets work. These mechanics form the principles that guide the construction of our systematic investment strategies. We hope sharing these provides a deeper understanding of our approach and ongoing macro conditions.

Today, we turn to a topical and often discussed subject: Stock Market Valuations. Market valuations are often discussed in financial media as a harbinger of things to come. Amongst market practitioners, their usefulness and quantification are frequently a polarizing subject. This polarization has been primarily driven by the underperformance of value-based approaches over the past few decades. This underperformance has led many investors to forgo all value-based measures in their investment process and some to look for alternative definitions of value. At Prometheus, we think valuations are an integral part of understanding expected equity market returns, which can provide significant insight for macro alpha generation.

Let us begin by defining equity valuations in the conventional wisdom. Equity valuations are a measure that reflects how much investors are willing to pay for stocks based on the expected future return the business can return to shareholders. This measure can be defined in an extremely wide variety of ways, usually in the form of price ratios— price to earnings, price to book, price to intangible investment, etc. While these measures are all modestly different, their core premise is the same— they seek to depict a relationship between price and the stock’s underlying value. Often, these price ratio measures are compared against their history to understand whether equity markets are cheap or expensive. Essentially, these measures use the fundamental value of the business as an anchor for price and seek to predict stock prices based on whether stock markets are cheap or expensive. This was a successful approach for many decades, but in the modern investment era, this type of approach has been less successful.

At Prometheus, we approach valuations differently from most investors. We use valuations not to predict prices but to estimate the pace of shareholder yield. This distinction is simple but extremely powerful. For further clarity, we decompose equity market returns:

Stock Returns = Dividends + Buybacks + Price Appreciation

It is well documented that most of the variation in stock returns comes from price changes. However, it is less well documented that most of the trend in long-term returns for equities comes from dividends & buybacks, also called shareholder yield. In fact, the majority of long-term equity returns can be attributed to shareholder yields. Thus, we think a comprehensive approach to investing requires a significant focus on understanding the dominant drivers of shareholder yield. In particular, earnings yields are the dominant driver of shareholder yields.

This is because the ongoing pace of earnings relative to the equity price determines how much the stock can return relative to the cost of its shares. Said differently, a company’s earnings yield potentiates its stock’s prospective dividends and buybacks. The higher the earnings, the greater the potential for dividends and buybacks. Even if these earnings are not returned to shareholders directly and reinvested, they potentiate future dividends and buybacks. Thus, the higher the earnings yield on an equity, the better the expected outcome for an environment where the price does not change. This return type, generated independent of price movement, is often called carry. Thus, we believe valuations, in the form of earnings yields, are highly informative of the carry for holding equities.

All else being equal, we want to own assets with a high carry level and avoid assets with negative carry characteristics. Now, while it is clear that positive carry is a good thing and negative carry is not, it is less clear what carry levels are attractive. Like all macro assets, we think the value of carry is determined not just relative to the asset’s history but relative to the carry of other assets like cash, bonds, and commodities.

Our systematic study of history has shown that a cross asset evaluation of the carry available in equities relative to other assets, offers a signficant edge over the traditional valuation approach. We think this gap exists due to the positives of the approach we have outlined, but also due to inherent flaws in how valuations are conventionally used. The most common use of valuations is to take various valuation ratios (price/earnings, price/book etc) for a given security, and compare today’s valautions to those seen over history. In this common approach, the higher the valuation versus the historical average, the more negative the outlook for the stock, with the expectation that valuations will mean-revert to historical averages. We belive that this method has several issues:

• Carry. While equities prices may be high relative to history, their earnings may well be positive, creating a stable undercurrent for dividends and buybacks, which in turn support total returns. Shorting or avoid an asset that has a positive carry is unlikely to yield positive outcomes.
• Momentum. One of the most persistent and pervasive phenomenon across markets and time is momentum. Macro cycles are self-reinforcing dynamics, and traditional valuation techniques by their construction find themselves reducing or shorting equities just as momentum rises. This effectively creates a bet against one of the most perisstent and pervasive phenomenon in all of investing.
• Mean reversion. Traditional valuation measures are largely suboptimal mean reversion bets. This suboptimal nature is due to the extremely large variance of stocks prices relative to their earnings, along with significantantly higher price appreciation of stocks over time relative to earnings. These varying charcateristics make tradtional valuation ratios a bet on mean reversion between a large and volatilie item (prices) and a small and stable item (book value, earnings, sales etc.). This makes the price component of the equation a very large overweight, essentially creating a counter-trend indicator. Mean reversion exists in every market, including equities, however, traditional valuation dynamics capture these poorly.

Reflecting these factors, our work has shown that the subtle shift from traditional valuation measures like price to earnings, price to sales etc relative to their history; to our preferred approach of estimating equity carry relative to other macro assets yields creates a much more effective lense for evaluating the relative attractviness of equities over time. We think this nuanced approach is an integral part of understanding one component of expected equity market returns, which can provide significant insight for macro alpha generation.Of course, there is a significant amount of work that needs to be done other than accounting for equity value when trading stocks, but this mechanical understanding forms an integral pillar of our understand.