Augmenting Price-Earnings Information With Price Inflation Information To Make Better Asset Allocation Decisions

The co-ordinated policy response amongst the world's central bankers has involved an extraordinary loosening of monetary policy since the middle of 2007. As eidence of this, leading lending rates in many parts of the world are at or close to zero percent (Japan, the United States, Canada and the United Kingdom stand out). To boot, the policy of quantitative easing that has been widely adopted means that new money is being supplied by the truckload at these exceptionally low rates of interest. This policy stance raises the possiblity that price inflation, which flows from such abundant printing of money, may come to replace economic recession as the collectively feared macroeconomic variable in the not-too-distant future.

Given this backdrop, it is worth considering the role played by price inflation in influencing equity returns. In this regard, the note below summarises the arguments and evidence in the case of South Africa drawn from an article to be published by the South African Journal of Economic and Management Science. The finding is a simple one: it is not the price-earnings ratio alone or the price inflation rate alone that matter to future equity returns, but rather a combination of the two. This justifies augmenting the price-earnings ratio, which stands as an exceptional predictor of future returns, with price inflation information to produce better predictions of future equity returns.

The arguments and evidence are summarised below and, for the interested reader, detailed in the attached note.

A SUMMARY OF THE PRICE-EARNINGS AND PRICE INFLATION ARGUMENT

There is a wide body of evidence which shows that, all else equal, low price-earnings ratios on equity markets correspond with higher future returns and vice versa. However, periods such as the mid-1990s witnessed above-average price-earnings ratios on some of the world’s largest equity markets, yet equity returns also were above average. This result encouraged market participants to go in search of new asset allocation tools.

One candidate that has been presented is a simple modification of the price-earnings tool, the Rule of 20 metric, which is the sum of the price-earnings ratio and consumer price inflation. The rule holds that price-earnings ratios should be high in periods of low price inflation and low in periods of high price inflation. In turn, a rule of thumb is brought: when the price-earnings ratio and inflation rate add to less than 20 the equity market is cheap. Conversely, when the figures sum to more than 20 the equity market is expensive.

In this vein, international research has found that the Rule of 20 is better at forecasting equity market returns than the simpler price-earnings yardstick. Further, it has been shown that the rule is effective in informing asset allocation decisions.

The available evidence confirms this result in the South African environment. Specifically, using 25 years of data, the evidence shows that an inflation-augmented price-earnings ratio (simply the sum of the inflation rate and the market's price-earnings ratio) is more effective in forecasting equity market returns than the simple price-earnings tool. Further, the evidence shows that the refined valuation tool can be used as a profitable asset allocation tool.

Apart from the strong empirical result, the attractiveness of the tool is aided in that it is easily understood and readily applied. On this front, it is interesting to note that the JSE currently trades on a price-earnings ratio of just less than 10 times which, if added to price inflation of just over 8 percent, yields an inflation-augmented price-earnings ratio of 17.9.

Compared to the past 25 years, this reading places the JSE in the lowest inflation-augmented price-earnings ratio quintile. In turn, as the figure below shows, readings in the lowest quintile have been associated with top quintile returns from equities.

In short, if history is anything to go by, the inflation-augmented tool tells us that equities are cheap.

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