EquitiesAug 12 2014

‘Hysteresis’ effect may mean markets are misvalued

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One of the perennial debates surrounding equity markets is the question of valuation. Most investors will have their preferred method of valuing the market and these methods can be quite different.

Aside from backward-looking approaches, such as looking at the price-to-book ratio or the cyclically-adjusted price-to-earnings (Cape) ratio, many managers turn to a forward-looking ‘discount model’ to value companies and their potential future growth.

This discount model commonly uses a three-stage process that tries to establish a net present value (NPV) of a company by estimating its future earnings.

But, at a certain point, this model stops making estimates of future earnings for a particular company (generally because it is too difficult to predict so far into the future) and from then on takes into account the potential future growth rate of the economy in which the company is based.

So, at the ‘third stage’ of this discount model, the growth rate predicted for companies becomes inextricably tied to that of the economy in which it resides.

So what would it do to valuation ratios if it turns out that the potential growth rate of an economy is significantly lower than currently thought?

The question has been posed by Robert Jukes, global strategist at discretionary management firm Canaccord Genuity, based on an academic paper produced this year looking at ‘hysteresis’ and potential growth rates.

The paper, entitled ‘Long-term Damage From the Great Recession in OECD Countries’, was published in May by Lawrence Ball at Johns Hopkins University in the US.

In it, Mr Ball looks at how the great recession may have affected future growth.

The idea of a recession permanently damaging a country’s long-term growth potential is called ‘hysteresis’ and comes about because a recession “reduces capital accumulation, leaves scars on workers who lose their jobs, and disrupts the economic activities that produce technological progress”, states the paper.

Mr Ball’s research, which also examines other recent works on such effects by economists like Larry Summers, suggests the hysteresis effects from the great recession may be particularly strong.

Mr Jukes points out that many of the hallmarks of hysteresis, such as “lack of corporate investment” and “underutilisation of labour”, seem to be evident in the US and UK, and could even explain the lack of productivity, which has puzzled economists.

Such effects seem to be particularly acute in the UK, which the study suggests has experienced a larger drop in potential growth than the likes of Japan, the US and Germany.

But Mr Jukes has taken the research one step further. Current UK equity valuations are pricing in a certain level of long-term growth, but this hysteresis effect means long-term growth may actually be lower, so Mr Jukes argues that equity valuations are in fact pricing in too much growth and should be lower.

Mr Jukes explains: “Reducing the estimate of potential growth (as per Lawrence Ball) will clearly have a negative effect on equity valuations, all other things being equal.

“At the moment (with interest rates at a historic low) more than 50 per cent of the equity market valuation is determined by the potential growth rate in the third stage of the model.

He adds: “Reducing the potential growth rate by 70 basis points reduces the NPV by just over 15 per cent.”

Mr Jukes also thinks that estimates for the ‘cost of capital’ may also have to rise by about 50 basis points, which would reduce the NPV of companies by a further 20 per cent.

He concludes: “In order to offset the negative valuation effects described [earlier], earnings growth would need to grow more than twice the rate it is currently forecast in each of the next five years.”

He admits that the presence of the hysteresis effect, which could permanently lower the growth potential of economies, can be disputed and that there is no ironclad evidence that such an impact is currently being felt in the UK.

In the face of this uncertainty, Mr Jukes says we should “deflate [the] estimates of the lower potential growth by the likelihood of that outcome”, but says markets are wrong to be completely “shrugging off” the idea of hysteresis.

Mr Jukes is currently undertaking a sweeping study of the entire global universe of stocks that he analyses for Canaccord, looking to calculate the impact a reduction in long-term growth would have across the entire market.

The research will likely add fuel to raging debates over whether developed market equities, particularly in the UK and US, are in need of a correction.

But Mr Jukes says the research may also throw up some interesting results at a company or sector level as well.

He says: “Long duration sectors such as pharmaceuticals or utilities may react less well to lower estimates of potential growth and higher interest rates than the rest of the market.

“Whichever way this scenario pans out there will be clear winners and losers at the sector and company level – we’ll be able to say more about that when we have the analysis from the data.”