Saturday, December 31, 2011

Auld Lang Syne: Remembering 2011

There are only a couple of hours left in 2011 in New York and it is already the new year in many parts of the world. Let me spend my last post for this year, looking back at the year that was and looking forward to the year to come, using a few of my favorite market props: cash flows/earnings, market prices, risk free rates and risk premiums.
  1. It was a good year for earnings at US companies, with earnings on the S&P 500 companies rising about 16%. That makes what happens to stock prices a little puzzling, since the S&P 500 index started the year at 1257.64 and ended the year at 1257.60. As a result , the aggregate PE ratio for the index declined from 15.03 at the start of the year to 12.96 at the end. 
  2. It was an even better year for cash flows: dividends on the S&P 500 companies rose 12.5%, but buybacks surged more than 80%. The total dollar buybacks in 2011 (at least for the four quarters ending September 2011) almost matched buybacks in 2006, though they still remained well below the historic highs set in 2007. While the dividend yield on the index remained anemic (2.07%) the total cash flow (including buybacks) yield on the index was 5.90%, again well above the ten-year average of 4.72%.
  3. The ten year treasury bond which started the year at 3.29% ended the year at 1.87%, the first time it has ended a year at below 2% in the last 50 years. The drop in the  rates also made US treasuries one of the better investments for the year, with the ten year bond returning 16.04% for the year; the price appreciation component accounted for 12.75%. Ironic, don't you think? After all, this was the year of the great S&P downgrade of the US sovereign rating that I talked about on my summer vacation in August. Are lower interest rates good news? I don't think so and I posted on the point earlier this year.
  4. As many of you know, I have been estimating an implied equity risk premium for the S&P 500 for a long time, annually until 2008 and monthly since September 2008. I back out the premium using the level of the index and expected cash flows in the future. The premium started the year at 5.20%, surged during the summer to hit a high of 7.64% at the end of September and ended the year at 6.04%. The fact that stocks were flat for the year (the return with dividends was 2.07%) had the opposite effect on the historical risk premium (where you look at the difference between annual returns on stocks and treasuries over long periods of past history), with the historical risk premium dropping to 4.10%. After a long period (1981-2007), where historical risk premiums exceeded implied premiums, this is the fourth year in a row that implied premiums have exceeded historical premiums.


So much for last year! What does all this tell us about next year? It strikes me that the numbers are sending discordant messages. The earnings and cash flows point to a recovery, at least in corporate earnings, the treasury bond market is awfully pessimistic about future growth and the stock market vacillates between euphoria and despair. I really have no idea what next year will bring, but I am willing to make a guess. I expect the treasury bond market to grudgingly acknowledge higher economic growth prospects and move up (to 3%), equity risk premiums to become less volatile and move back towards lower numbers (5-5.5%). Buybacks and dividends will stay strong but will stabilize and earnings growth will moderate. The net effect will be to make the stock market a more hospitable place to invest and the bond market a less attractive investment. So, I am adding to my equity exposure, selling my treasury bonds and praying that the Eurozone does not turn my predictions to dust.

I apologize for both the US-centric and macro nature of this post but I am starting on my annual data update this week. Over the next ten days, I will be exploring the raw data that I have downloaded on 50,000+ companies globally, since the close of trading yesterday, and will be generating my industry average tables. During that analysis, I will be looking at how equities have moved globally and world-wide trends in both valuation multiples (PE, Price to book, EV/EBITDA etc.) and corporate finance variables (dividends, debt ratios, returns on equity/capital). I will have a much more detailed post when I am done but I look forward to learning a great deal more from the numbers than from listening to expert prognostications. 

So, happy New Year! I wish you, your families and your loved ones the very best for the coming year! Be happy and healthy!

16 comments:

Immortal said...

Wish you the Same Prof :)

mik said...

Happy New Year, Professor! Lots of luck and joy in the new one.

Anonymous said...

Thank you as always for your posts, Professor. Happy New Year to you too.

James said...

Happy New Year as well :) Thanks for such a great blog.

Vinicius Caldas said...

Have a great 2012, Professor. All of the best to you and your family. :)

Anonymous said...

Thanks Professor for this insightful blog, New year greetings to you, your family and loved ones !

Sreeram said...

Happy New Year Sir.

mrugen said...

Same to you to Professor. and thanks for such informative blog and other knowledge you gave for free of cost.
Hope to attend your lecture here in India one day.

Dhanan said...

Thanks for ur guidance through ur post & website looking forward for the same in the coming years. Wish u and ur family a happy new year 2012

Shawn S said...

This is an interesting post, the concept of the equity risk premium is a very loaded subject since it is basically solely responsible for capturing how the market will reward those who take on increased levels of "risk." First and foremost, it's interesting to observe the difference between the historical and implied premiums as this in some ways a larger commentary on general fear in the marketplace. It's very similar to how in the insurance industry after a natural disaster (that is not necessarily out of step with actuarial expectations), pricing will often harden because of the very behavioral element that comes with the ebbs and flows of the bull and bear market. Would be interested to hear your opinion, but I wonder if this difference also necessarily violates rational expectations hypothesis since it may imply that people are systematically bad at predicting expected future outcomes. Perhaps another interesting way to look at the equity risk premium would be to try and determine if there is skew in the risk profile of returns (I will be honest, off the top of my head I do not know how you would easily observe this). It seems that most finance theory conveniently assumes all outcomes are stochastic (and therefore symmetric), but if you could determine if there was skew in the returns profile, it could allow you to know when to take on more systemic risk when things are stacked a little more in your favor.

ashwini chube said...

Wonderful and very informative post Sir..Your blog is wonderful and I enjoy reading it..Wish you a very happy new year too

Meenakshi Murthy said...

Thank you Sir quite helpful...Happy New Year..:)

Pranav Pratap Singh said...

Wish you and your dear ones a very happy new year!
As always waiting for your next post.

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