The Uncertainty That Matters Quantitative Strategists – the Drag on the Market Joseph J
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Quantitative Desk Strategies April 17, 2013 The uncertainty that matters Quantitative strategists – the drag on the market Joseph J. Mezrich [email protected] ° What is measurable and what matters are not always the same – uncertainty over economic 1-212-310-4241 policy is currently more relevant than market volatility (VIX) in setting the equity market’s level. ° Economic policy uncertainty – as measured using the three-component index proposed by Yasushi Ishikawa Baker, Bloom and Davis (2013) – does not equate to market volatility, a common indicator of [email protected] uncertainty. The former is high at present and the latter is low. Except in the March 2009-May 1-212-310-4106 2010 period, economic policy uncertainty has closely tracked the long-term earnings growth priced in equities. Instinet, LLC ° The economic policy uncertainty index today is far higher than before 2007, indicating 1095 Avenue of the Americas New York, N.Y. 10036 substantial economic policy uncertainty exists, pushing down implied long-term earnings growth in equities to around 0.2%. This is in sharp contrast with the 11% implied growth at the 2007 market peak. We conclude the market would move substantially higher on the back of improved implied earnings growth if economic policy uncertainty declined – we estimate the S&P 500 could rise 12% to 1740 if implied long-term earnings growth rose to only 3% on reduced uncertainty. Earnings growth implied in equities closely reflects economic uncertainty Implied earnings growth in equities and economic policy uncertanity 15 -20 14 Prior high 13 of S&P 500 12 This market commentary is a 11 30 Index Uncertanity Policy Economic general discussion, and not a 10 9 recommendation for any 8 particular customer to take or 7 80 refrain from taking any action 6 with respect to any securities or 5 4 Average earnings growth in S&P500 130 strategies discussed therein. 3 since World War II ( 7.1% ) See last page for important 2 disclaimer information. 1 0 180 -1 You have received this material -2 because you are an -3 institutional investor that has -4 230 expressed interest in receiving (%) growth earnings long-term Implied -5 Implied long-term earnings growth in S&P 500 -6 Quantitative Desk Commentary -7 Economic policy uncertainty index provided by Instinet, LLC. If -8 280 you have received this in error, please alert the sender to be Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 immediately removed from the May-13 distribution list. Note: Shows the implied long-term earnings growth (LTG) of the S&P 500 (dark blue line) and US economic policy uncertainty index (reversed, light blue line). Implied LTG (from FY1 to FY5) is derived by inputting the expected equity risk premium in Duke University’s CFO survey (4.0% in March 2013 survey), based on a residual income model. Last data points are as of 17 April 2013 for implied earnings growth and 31 March 2013 for economic uncertainty index. Source: Instinet, Graham and Harvey (2012), http://www.policyuncertainty.com/, I/B/E/S, S&P, Compustat, IDC. HIGH-TOUCHTRADING | ALGORITHMICTRADING | FRONT-ENDTECHNOLOGY | LIQUIDITYSOURCING | TRANSACTIONANALYSIS | COMMISSIONMANAGEMENT | INDEPENDENTRESEARCH The uncertainty that matters – the drag on the market What is measurable and what There is an old joke about the fellow who lost his keys in the street one night. He looked for them under a matters are not always the lamp post, not because they were lost there, but because that was the only place there was light. same – uncertainty over Similarly, there is often confusion between what you can measure and what matters. Volatility is often economic policy is currently taken as the indicator of market uncertainty, but the uncertainty that matters may not be reflected in more relevant than the VIX in measures such as the VIX. The point of this report is to highlight the role of economic policy uncertainty setting the equity market’s as directly related to how the market prices itself. Lately we find economic policy uncertainty is more level relevant than the VIX in setting the equity market’s level. The S&P 500 broke into record territory this month, recently dropping below the October 2007 record. The S&P 500 is now pricing Whether the market will continue higher after the current pause depends to a great extent on what the 0.2% annualized earnings market is pricing for future earnings growth. Our analysis indicates the market is pricing a very subdued growth over the next five 0.2% annualized earnings growth over the next five years. That is in sharp contrast to the 11% growth years, well below 11% at the priced at the 2007 market peak, which was well above the average historical growth of 7% delivered by 2007 market peak and the S&P 500 companies since World War II. At the October 2007 peak the market was expensive in terms of historical average of 7%, likely the growth that was being priced. Currently, with the market above the 2007 peak, the market looks because economic policy cheap based on the growth that is being priced. Economic policy uncertainty is likely depressing growth uncertainty is depressing expectations. That conclusion is based on a comparison between our estimate of the market’s implied growth expectations earnings growth and uncertainty as measured by the economic policy uncertainty index recently introduced by Baker, Bloom and Davis (2013). Economic policy uncertainty – Economic uncertainty, as measured by this index, is based on three components: one measuring as measured by the economic newspaper coverage of policy-related economic uncertainty by counting the mention of policy uncertainty policy uncertainty index in ten popular newspapers, the second measuring the number of federal tax code provisions set to expire (Baker, Bloom and Davis, in future years, and the third measuring disagreement among economic forecasters as a proxy for 2013) – does not necessarily uncertainty. According this index, economic policy uncertainty is not reflected in market volatility. That is equate to equity market seen in Exhibit 1, which plots the history of the economic policy uncertainty index and the VIX. The index volatility (VIX): the former is of economic policy uncertainty has been very high since 2009, whereas the VIX has collapsed. In high at present and the latter contrast to the VIX, the relationship between economic policy uncertainty and the market’s implied is low (Exhibit 1) earnings growth is striking. That is seen in Exhibit 2. 1. Equity market volatility is low, but economic uncertainty is still high Economic policy uncertainty and equity market volatility 60 300 Lehman Bankruptcy Debt Ceiling Dispute: Euro Debt 50 WorldCom 250 index Uncertainty Policy Economic Russian Crisis; Scandal LTCM 2010 Fiscal Asian financial Gulf War II Midterm Cliff 40 crisis 9/11 Elections 200 Gulf War I Clinton Large interest Election rate cuts 30 150 VIX 20 100 10 50 VIX Economic Policy Uncertainty index 0 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Note: Shows US economic policy uncertainty index (monthly) and VIX index (implied volatility of one-month S&P 500 index option). Period of analysis is from January 1990 through March 2013. Source: Instinet, http://www.policyuncertainty.com/. 2 The method we use to The implied long-term earnings growth priced in the S&P 500 is a measure of the cash market’s calculate the implied long- sentiment. If we assume the current level of the S&P 500 is the market’s estimate of the discounted term earnings growth in the present value of future earnings, then given analysts’ consensus expectations of earnings over the next S&P 500 (see Appendix for two fiscal years and an estimate of the expected equity risk premium, we can calculate the market’s detail) implied long-term earnings growth. For this analysis, we aggregate I/B/E/S consensus FY1 and FY2 analyst earnings forecasts for stocks in the S&P 500 and use the Duke University CFO survey for the expected equity risk premium. The discount rate is taken as the 10-year Treasury yield plus the Duke University CFO survey estimate of the expected equity risk premium (for details, see Appendix). Except in the March 2009- The history of implied long-term earnings growth in the S&P 500 is shown as the dark blue line in Exhibit May 2010 period, the 2. The red horizontal line on the left in Exhibit 2 is the average experienced earnings growth since World economic policy uncertainty War II, about 7%. The market’s implied earnings growth tended to price this historical level of about 7% index has closely tracked until the Lehman bankruptcy, but has been gyrating since the crisis erupted as it hunts for equilibrium. As implied long-term earnings Exhibit 2 shows, the implied earnings growth has gone negative, recovered, and gone negative a number growth in an inverse of times over the past four years. The S&P 500 implied earnings growth is now slightly positive, but well relationship – implied long- below the 3% earnings growth indicated by the horizontal red line on the right of Exhibit 2 – a level that term earnings growth is now has been touched a few times since 2009. The index on economic policy uncertainty has tightly tracked only 0.2% (Exhibit 2) .