Thursday, October 9, 2014

Unexpected Returns

A lot of effort has been spent trying to determine whether the stock market is over- or under-valued. But over decades and generations, what is it that leads to these extreme changes in market valuation? In Unexpected Returns, Ed Easterling identifies the factors that cause valuations to change.

Interest rates as the primary causal factor of market valuations is the guess most people would make, I suspect. However, Easterling makes a reasonable case that it is actually inflation that is the key factor. Easterling makes a good case that in both deflationary and inflationary environments, P/E levels fall into the teens and below; during stable inflation environments, P/E's spend most of their time in the 20's.

Of course, unless you can predict the changes in inflation that are to come (and the book makes no attempt to help you do that, and I'm not sure any book can), I'm not sure how this information is useful. When valuations are high, Easterling offers some strategies that don't rely on a rising market to generate returns (including hedging and porfolio rebalancing), and when valuations are low, Easterling suggests going all in to benefit from the market's tailwind.

I thought the strategies were a little simplistic, as they were limited to macro strategies, with absolutely no mention of bottom-up or fundamental investing. I also think using P/E as a judge of market levels can be misleading since earnings are so prone to fall/rise dramatically; using CAPE instead would bolster his findings, in my opinion. The book also drew a lot of conclusions from dividend yield levels as they have changed in the US markets over time; however, it misses the key trend towards buybacks as a legitimate capital-returning tool (i.e. a substitute for dividends) that has taken place in the last couple of decades, rendering some of the dividend analysis kind of useless in my view. Finally, I think the book could have benefited by using some international data, to confirm some of the book's findings that may have just been co-incidental within US markets.

If this topic interests you, I instead recommend not this book but rather Meb Faber's books, Global Value and Shareholder Yield. I think Faber's book is both more practical and makes a better case using data.

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