Friday, March 15, 2013

Beyond Buffett: Liquidity-adjusted equity valuation

One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as "marketability" and "liquidity," sing the praises of companies with high share turnover . . . but investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pick pocket of enterprise. - Buffett

Our favorite holding period is forever -
While Warren Buffett may not be fond of marketability, liquidity or short holding periods, the fact that stocks have moneyness—that they have varying degrees of liquidity—is vital to understanding stock prices. In this post I'll show why analysts can't ignore the liquidity factor when they try to evaluate whether today's S&P500 is over or undervalued.

With equity markets setting new highs by the day, the chorus of fundamental analysts shrieking "overvalued" is deafening. These analysts often buttress their point by an appeal to some sort of benchmark valuation metric, like Robert Shiller's cyclically adjusted price to earnings (CAPE) ratio. The "cyclical adjustment" bit refers to the fact that the divisor, earnings, has been smoothed over several cycles, in this case the last ten year's monthly earnings.

The average CAPE since 1881 has been about 16.5x. Today we are currently paying a hefty 22.9x for each dollar of cyclically-adjusted earnings. In order to return to the long run average of 16.5x, the S&P500 would have to plunge by around 28%. That's quite the bear market.

In the chart below I've flipped the cyclically adjusted P/E ratio upside down into an E/P ratio, or a measure of the S&P500's earnings yield. The earnings yield indicates what sort of cyclically-adjusted fundamental return investors might reasonably expect for each dollar they invest in the stock market. The yield currently clocks in at 4.4%, far below the historical median of 7.1%, and way lower than some of the more juicy returns of 10-15%.

The point that fundamental analysts take from this chart is this: why invest in stocks if they don't yield anything close to their long term average?

Adding liquidity to the valuation equation

The fundamental analyst's appeal to Shiller's CAPE ignores the fact that a stock yields not just a pecuniary earnings return, but also a non-pecuniary liquidity return. Stocks are moneylike—put differently, they have moneyness. This feature is valuable. The knowledge that a given good or asset will be relatively easy to sell in the future provides its owner with a degree of comfort. After all, if something unexpected happens to the owner—a tree falls on his house—he'll be able to quickly exchange away those liquid assets in order to get started on home repairs. Less liquid assets don't provide the same level of comfort. Their owner can never be sure that they'll be able to easily sell them should a tree fall, or a storm hit, or a car crash. Assets with higher degrees of moneyness provide greater discounted flows of comfort over time.

Because liquidity is a valuable property, any asset's return should be broken down into the pecuniary returns it provides (dividends + appreciation) and a liquidity return. The higher the liquidity return that an asset provides, the smaller the pecuniary return it need promise potential investors. For example, even though the pecuniary return on Federal Reserve notes is negative (ie. the market expects slow and steady inflation), people still hold notes because their liquidity return is so high. Or consider the difference between savings and chequing deposits. A savings deposit is frozen for a period of time whereas a chequing deposit is easily transferred. To compensate investors for foregoing the liquidity of chequing deposits, savings deposits need to provide higher pecuniary returns in the form of interest.

How high is a typical stock's liquidity return? Unfortunately I can't tell you since the ability to back out a stock's liquidity return from its overall return doesn't exist. While I won't hazard a guess about the current liquidity return on stocks, I'm pretty sure I know its shape over time. Due to institutional innovation, a modern stock's liquidity return is *far higher* than it was in the past. Put differently, stocks are more moneylike than ever.

Because they have been honed to provide ever higher liquidity returns, a modern day stock simply does not need to provide the investor with the same cyclically adjusted E/P yield that it did in the 1950s or 1960s. Just like a chequing deposit doesn't need to provide the same return as a savings deposit, today's stocks don't need to provide as much per-share earnings potential as yesterday's stock. This means that you should be very careful about mining Shiller's long term data for clues about present-day valuation since you'll be effectively comparing apples to oranges or, more correctly, illiquid shares to liquid shares.

Institutional changes increase the ease of transacting in shares

Here is a list of ways in which equity markets have evolved over time to increase the moneyness of equities.

1. Falling fees: Prior to 1975, the NYSE required that all members set minimum commission rates. Competitive pressures from over-the-counter exchanges (along with SEC pressure) finally convinced the NYSE board to deregulate commissions in 1975, the famous Mayday episode. In Canada, the changeover date was 1983. As the chart below shows, commissions plunged.

Figure from A Century of Stock Market Liquidity and Trading Costs - Jones (2002)

In addition to lower commissions, the emergence of competing exchanges like NASDAQ in 1971, and, more recently BATS, Direct Edge, and various dark pools, have led to ever lower exchange trading fees. Lower fees make it easier to get in and out of stock, rendering stock more useful as exchange media. A direct result of Mayday, for instance, was Charles Schwab and the discount brokerage boom, a phenomenon which dramatically increased the pool of investors and deepened liquidity in equity markets.

2. Collapsing bid-ask spreads: The influx of high-frequency traders has dramatically compressed the average spread between a stock's bid and ask price. But even before then, bid-ask spreads had been on a long term decline:

Figure from A Century of Stock Market Liquidity and Trading Costs - Jones (2002)

New practices like decimalization, implemented in Canada in 1996 and the US in 2001, have contributed to spread shrinkage. Stocks used to be quoted in eighths of a dollar. This was changed to sixteenths in 1997, but the practice of quoting in narrower fractions only meant that the minimum spread was now 6.25 cents rather than 12.5 cents. Decimalization allowed the spread in liquid stocks like MSFT to shrink to a cent or two. We're even seeing sub penny spreads these days, an impossibility just two decades ago.

Like lower commissions, narrower spreads make it easier to transact, therefore increasing the moneyness of stock.

3. Back-office changes: In the old days, stocks were traded in certificate form. When stock was exchanged, brokers employed "runners" to carry certificates from one broker to the other. In the late 1960s, to deal with backlogs, certificates began to be immobilized at central repositories. All trades were transferred by book entry, a far easier process than before. Nowadays, certificates are being dematerialized, meaning that they are being converted into digital form. All this makes trade in stock safer, more convenient, and cheaper.

In the 1930s, the convention was to settle stock trades five days after trade day, or T+5. We are now at T+3 and moving to T+1, or straight-through processing. Again, the trade process is speeding up.

4. Standardization and transparency: The increasing adoption of universal accounting standards and practices have increased the quantity, quality, and comparability of information emitted by public issuers. Investor relations departments of listed firms are far more concerned than in times past about the equitable distribution of information. Insider trading, while illegal in the US since 1934, has become increasingly frowned upon in practice. Equity research has become more formalized, ensuring that information is more efficiently processed.

As a result of all these changes, the perception (if not the reality) exists that the stock market is no longer the loaded game of yore, when investors were typically pitted against a clique of operators with inside information and tight control of a company's float. Rather, the modern day stock market offers a flat playing field. This homogeneity and verifiability has set the stage for stocks to become more moneylike.

5. Longer trading days: The NYSE used to open at 10 a.m. and close at 3 p.m, an easy five hour trading window. While the Exchange also opened on Saturday morning, the window was only for two-hours, a practice that ended in 1952. Nowadays, NYSE ARCA, the NYSE's electronic trading platform, opens at 4:00 AM and closes at 8:00 PM.

Due in part to all these changes, share velocity has exploded. Put differently, the average holding times of NYSE stock has plunged from 8 years in the 1960s to around 12 months today:

Liquidity-adjusted fundamental analysis

Fundamental analysts, who frame investment decisions as if they'll own a stock forever, dislike this trend. To them, the equity market's increase in velocity, combined with a 23x PE ratio, represents a maddening increase in silly speculation. All they can do is sit on the sidelines and snipe.

On the contrary, the rapid increase in share velocity isn't silly, it simply reflects the market's growing willingness to treat stock like cash on the back of constant institutional innovation. Cash is useful because it is liquid and can get you out of a bind. Same with modern-day stock. Rather than treat high PE ratios and the increasing velocity of stock as products of irrationality, fundamental analysts need to understand that the premium put on liquidity is the market's reward for a very real transactional service provided by stock. What should fundamental analysts do? Stop trying to figure out if a stock is overvalued or not. Rather, try and find out if that portion of a stock's value not attributable to liquidity is overvalued or not. Or, put differently, try to strip out the liquidity return provided by a stock in order to focus purely on the real return. This amounts to calculating a liquidity-adjusted CAPE. But that's a post better left for next month!

Summing up...

A stock today is not your grandfather's stock. Stock can do more moneyish and cashlike things. It can be exchanged faster, safer, and cheaper. Because such a large chunk of a modern stock's returns now arise from their moneyness, fundamental analysts shouldn't be using earnings yields from the 1900s, let alone the 1800s, as a baseline for estimating modern yields. As long as the decades-long process of liquefying stock continues, it's very likely that the market will never again require stock to provide 7.1% returns. Today's 4.4% yield might be more normal than most think.

[This post is continued at If your favorite holding period is forever]


  1. Great article.

    I can see how the things that you list would increase moneyness of stocks.

    How does volatility affect this moneyness ? Right now I think one could make a case for a 20% +/- chnage in the s&p over the next year. Its fine to know I can sell stocks at a low transaction cost to meet unexpected expenses - but if I need the money after a sharp fall in stock values its not so good.

    I suppose that as long as perceived volatility has remained constant over time then it doesn't affect the case you make here - but I was curious how volatility affects moneyness generally or if perhaps increased moneyeness affects volatility in some way ?

    1. I can't see volatility in prices encouraging liquidity. My guess is that a company that issued a class of shares that were permanently fixed at $100, but paid a rising/falling dividend, would be more liquid than a class of shares who's price floated.

      Vice versa, a thick and liquid market is unlikely to be as volatile as a thin one. Random noise trades are more easily absorbed by thick bid and ask spreads. It's a tricky question though... plenty of room for variations on a theme.

  2. Bid/Ask spreads are a constant source of debate given illusory High Frequency Trading quotes. Any attempt to trade in size triggers HFT front-running which creates an even thinner market. Lastly, volumes on the NYSE seem to be falling just as consistently as the market is rising. This is highly unusual as liquidity normally improves during rallies.

    I think your argument applied in 2006; I'm less sure it does in 2013.

    1. Keep in mind that at the core my argument is less about "is the market overvalued or not"... it's about trying to isolate liquidity and earnings components of equity returns so that we can be more precise in our thinking about asset prices.

      I agree with you that the shape of the liquidity curve has changed a bit over the last few years. The democratic nature of the market's microstructure is increasingly in doubt. It's tough to see, but the average holding period of NYSE stock has doubled since 2008. Stocks are less moneylike.

      What are our forward expectations about liquidity? Is the market's microstructure going to be repaired? Are we just going through growing pains? If markets do get repaired and stocks once again continue their trend to becoming more like money, 2013 prices could prove to be cheap.

    2. JP,
      I think there are two separate issues here: risk and uncertainty. Your post addresses liquidity risk and makes a good case for why it has fallen over time. One reason it has fallen is that buyside PM's are fighting back against HFT frontrunning with their own algorithms. This has led to a whole ecosystem of algorithmic "predators" and "prey". On a daily basis, this ecosystem functions fine, but underneath the surface it has driven traditional sources of liquidity to extinction. The net effect is that "risk" is lower but "uncertainty" is higher. We simply cannot know how this ecosystem will behave under certain conditions. For that reason, stocks are likely to attract a liquidity risk discount only after an effect manifests itself.

  3. Well-argued. But I'm unconvinced. Because:

    " Their owner can never be sure that they'll be able to easily sell them should a tree fall, or a storm hit, or a car crash."

    OK, those are just hypothetical examples, but what percentage of sales of stocks are sales that happen because of good reasons like that?

    1. Maybe a better example is from an interesting conversation on Twitter with Squarely Rooted:

      He thinks he'll buy a house at some uncertain point in the future. His point is that rather than investing in a small business he'll stay invested in stocks since they can be easily sold.

      "What percentage of sales of stocks are sales that happen because of good reasons like that?"

      It's not the after-the-fact analysis that's important. It's the expectations that go into formulating the initial purchase. Given worries about trees and house purchases, how often do stocks displace other assets from being purchased in their place? Prior to making portfolio changes, people compare the relative ease of eventually getting out of a given asset, subject to their degree of confidence in what the future has to offer. Relative to thousands of other assets, stocks have steadily become easier to get out, and thus serve as a better buffer stock against uncertainty.

  4. Why would you include data from the Gold standard era? The price level back then was mean reverting. I think the more relevant inverted CAPE average would be from 1971 onwards.

    1. Inflation definitely jumbles the equation up. Even post-1971, comparing the inflation targeting 90s and 2000s with the 1970s period of no-rules central banking is questionable. Earnings are a terrible indication of financial health during inflation, better to look at cash flow.

    2. Au contraire, E/P is a real yield, and so in unaffected by the inflation regime, to the first degree. So your use of E/P is perfectly justified.

      Also, you will be interested in taking a look at Holmstrim/Tirole's "Liquidity Asset Pricing Model" from the late 1990s. IMO the best recent work on the sort of stuff you like apart from Kiyotaki/Moore.

      Needless to say, excellent stuff!

    3. While in theory I agree that inflation doesn't affect real yields, in practice I don't this is the case because of historical cost deprecation and FIFO inventory accounting for cost-of-goods-sold. These costs are "slow" in catching up to revenues. As a result, during an inflation firms tend to pay higher real taxes on income than they would otherwise. Inflation hurts firms as opposed to being neutral. These detrimental effects will show up in cashflow accounts but won't be captured in income measures.

      In 1981 Larry Summers wrote a good paper on this. See here. I've been planning on writing a post on this for a while.

      I'll be sure to check out Holmstrim/Tirole. I've looked at Kiyotaki/Moore and while I get the rough idea I find their paper quite intimidating.

  5. JP, this was very interesting. Looking forward to hearing more about your liquidity-adjusted CAPE. The long-term decline in yields in "safe assets" seems to be another factor complicating the yield comparison.

    1. Thanks, hopefully I can write something soon.

      I've written about the safe asset argument here.

      The decline in safe asset yields could very well be due to the same forces that contributed to a decline in stock yields... the market's infrastructure has increasingly rendered bonds more liquid, reducing the necessity that they provide high coupons.

  6. JP,

    I just realised that you confirmed an argument that I've been making for a while (also in my thesis): there's an interrelationship between transaction costs and liquidity. Bitcoin exchanges, for example, trade 24/7, and are accessible by anyone from anywhere. So Bitcoin's "soft" attributes of liquidity are comparatively better usable than almost any other market. Even banks don't operate all of their services 24/7. And I'm not even talking about regulated stock exchanges, precious metal ETFs and so on. I always recall a story, when I arrived back to Dublin from the Bitcoin conference in Prague, and wanted to get rid of the Czech crowns, the airport exchange said they don't exchange foreign coins, only notes.

    Only ATMs, POS terminals and some online payment systems can really compare with Bitcoin (assuming there's no double coincidence of wants with cash, of course). But now we have a Bitcoin ATM: . I think that soon you'll be able to use Bitcoin practically anywhere, either directly or through integration with the existing fiat infrastructure (multihoming).

    1. Keep in mind that in the end we are interested in subjective liquidity, not objective liquidity. Bids-ask spreads, commissions, search costs etc are objective data. The market's subjective evaluation of these objective features and more importantly the market's forward expectations concerning them is the key to understanding liquidity. I think subjective liquidity manifests itself in the market as a liquidity premium, or the discounted value of future liquidity services provided by some asset. Analyzing objective liquidity factors is certainly important, but not as important as subjective factors.

  7. Wouldn't the moneyness of a stock be inversely related to beta?

    1. Donald, I suppose you could say that. Because such a large part of the return it provides is non-pecuniary, a very liquid stock doesn't need to keep up with the less-liquid broad market. I would expect an illiquid stock to rise at 2x the rate of the market to compensate me for its inferior moneyness.

      Is that what you had in mind?

    2. Exactly, but you would own the 2x stock for its appreciation potential not as a money substitute. I would venture that those who moved funds into dividend-paying stocks recently viewed them more as time-deposit substitutes than as a speculation.

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