Years of artificially low interest rates have led to artificially high stock prices with valuation indicators, such as Price-to-Earnings, Price-to-Book and Shiller’s CAPE (cyclically adjusted price-to-earnings), flashing red for some time now. And yet, notwithstanding recent volatility, stock prices resist gravity, making investors scratch their heads about what is keeping the stock market elevated.
In theory, it is fundamentals that determine stock prices. In reality, however, it is more than fundamentals that determine stock prices, especially in the short run. It is the underlying imbalances in demand and supply of whatever is being traded. It is such imbalance between the demand for and supply of stocks that, in my opinion, has been driving stock prices the last few years.
Lack of alternatives, especially for long-term investors such as endowment funds, sovereign funds and pension funds, has created a surge in demand for stocks at the same time that the supply of stocks is dwindling due to the aggressive buyback programs instituted by corporations in recent years. The combination creates an excess demand for stocks. In this article I highlight the lack of alternatives, the demand side, as exemplified by typical asset allocation recommendations to long-term investors, as well as the supply side, as exemplified by the shrinkage of stocks available in the markets, focusing on the U.S. markets where data is more easily accessible.
On the demand side
The aforementioned investors need a long-term strategy that can produce stability, and downside protection, with growth opportunities. As a result, they focus heavily on an equity portfolio using the Warren Buffett value investing approach covering different industries and different regions of the world. Fixed income securities are normally avoided, especially during these days of rock bottom interest rates, as they have very low expected returns. This aligns with the way Mr. Buffett sees things given a 2014 CNBC interview in which he said, “we are all equities ... we do not have any bonds in our pension funds.”
Unlike the pure Ben Graham approach, which targets obscure and unattractive stocks that can produce superior long-term performance, but with a lot of short-term volatility, the Buffett style of value investing targets companies with barriers to entry and sustainable competitive advantage. This strategy emphasizes quality investing and can produce adequate long-term performance with lower volatility and less sensitivity to the stock market. The two different styles’ performance is best exemplified by examining the stock returns of Berkshire Hathaway over two distinct time periods, namely 1965-1981 and 1982-2016, as Mr. Buffett was a Ben Graham investor early on in his career and sometime after 1981 his style evolved to quality investing. Between 1965 and 1981 Berkshire Hathaway beat the S&P 500 by about 20 per cent versus about 10 per cent between 1982 and 2016. The company’s worst return in the first period was -48.7 per cent (versus -26.4 per cent for the index in 1974) as opposed to the second period’s worst return which was -31.8 per cent (versus -37 per cent for the index in 2008).
Equity exposure by such investors is supplemented by investing in private equity to benefit from the illiquidity premium and/or small cap premium; infrastructure that offers good inflation protection, as well as stable yields; and real estate, which has good diversification characteristics.
Increased demand for equities is also emanating from other investors, as well -- as manifested by recent evidence. During the December 2017 to January 2018 period, investors bought US$58-billion of equity funds, the largest inflow ever according to Bank of America Merrill Lynch. Moreover, a December 2017 asset allocation survey conducted by The American Association of Individual Investors, and reported in Forbes, showed that 74 per cent of portfolios are allocated in equities.
On the supply side
Statistics on share buybacks provide undeniable evidence of the shrinkage in the supply of stocks in the markets. Total U.S. buybacks have exceeded US$3.5-trillion since 2010. This represents a lot of stocks taken out of the markets. Moreover, the recent U.S. tax reforms and other incentives given to corporations in the U.S. will further contribute to an increase in buybacks of US$875-billion, according to Bloomberg. For example, in February 2018, U.S. corporations broke previous historical records by announcing US$151-billion in new share repurchases according to California based firm TrimTabs, which follows corporate share buybacks. Furthermore, as reported by Canaccord Genuity analysts, there was a surge in repurchase authorizations in early 2018 suggesting many more shares will be bought and taken out of the stock market and daily trading.
The end result? Market liquidity has slumped as the volume of equities has severely declined over the last few years. For example, the volume of equity trading in 2017 was down 51 per cent compared to 2007.
Having said that, the U.S. tax reform may provide some unintentional reprieve. As I have described in a recent article I published in the Canadian Investment Review, the recent U.S. tax reform by making debt issuance relatively undesirable, it may give companies incentives to issue more shares mending some of the imbalances between demand for and supply of stocks in the U.S.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario