The Found Lost Decade

By Annaly Capital Management.

On Tuesday July 27th, the Census Bureau released homeownership rate data for the second quarter of 2010, which showed a continued decline to 66.9% from a peak of 69.4% in 2004. This rate hasn’t been below 67% since 1999, a round trip in just over a decade.

“Lost Decade” graphs have been all the rage in 2010, nearly as popular as phrases like “since the 1930s” and references to Japan (guilty as charged). We started taking a look at some other facts about the last 10 years, to see what happened, see if we can understand why, and to look for some clues about what the next decade might look like.

The period between 1999 and 2010 was not the period of robust wealth accumulation that many dreamed of when the new millennium dawned:

· Annualized nominal increase in household net worth since mid 1999: about 3.25%

· Annualized inflation since mid 1999: about 2.7%

· Real increase in household net worth:  an annualized 0.55%

After roughly 8% annual growth in nominal household net worth from 1952 through 1999, what happened?

1. No job growth. Job creation (nonfarm payrolls) since mid 1999: about 1.6 million jobs, or an increase of 1.25% in 10 years (not annualized, just 1.25% total).

2. Little income growth. Real personal income less transfer receipts rose at only 1.4% annually since 1999.

It’s hard to build net worth when there is no job or income growth, but we also didn’t get much help from our assets. The household has dealt with a volatile decade as its two biggest assets, real estate and equities, experienced back-to-back bubbles.

First, let’s look at the biggest single asset on the balance sheet, household real estate (bubble #2 in the graph above). Nominal home price appreciation in the decade ran at about 3.7% annually before inflation, according to the Case-Shiller 20 city index. Not a particularly strong showing, especially when you consider that household mortgage debt grew at more than 8.5%. An ironclad rule of investing: if you pay too much for an asset, you will enjoy subpar returns. Homes clearly got overvalued, but the ~25% decline from the peak has erased much of that overvaluation, bringing home prices back in line with incomes. The fact that this headwind has mostly died away is encouraging. That’s not to say that home prices can’t drop further. Overvaluations tend to over-correct, and the current over-supply situation should continue to put downward pressure on prices in the short term, but it appears that homes are mostly fairly valued.

Another large chunk of household balance sheets is allocated to equities in one form or another (bubble #1 above), which leads us to one of the most popular Lost Decade facts: the annualized total return on the S&P since July 1999 is only about 0.4%. That’s a full decade of near-zero returns in equities, the asset class that is supposed to give you anywhere between 6% and 10% annually depending on who you ask. What happened? Investors earn their total return in equities in two ways: dividends and price appreciation. The dividend yield on the S&P in 1999 was about 1.25%, nothing to get excited about. The current yield is only just above 2%. Price appreciation happens for two reasons: earnings growth and price-to-earnings multiple (P/E multiple) expansion. The annualized as-reported earnings growth for the S&P since June 1999 is roughly 3.4%, but the multiple on trailing earnings has compressed by about half in that time, from 33.5x to around 17x now (for the purpose of this analysis, we are using as-reported earnings…we’ll leave our complaints about “operating earnings” for another time). Let’s repeat our ironclad rule of investing: if you pay too much for an asset, you will enjoy subpar returns. It’s not likely that anybody will argue with the assertion that equities were overvalued in 1999. The two bear markets that investors have endured, along with growing earnings, have gone a long way toward fixing the overvaluation of the late 1990s, but are we all the way there yet? Professor Robert Shiller (of Yale and the Case-Shiller housing index) has an impressive data set of equity earnings, dividends and prices going back to 1871 which we’ve used for the analysis that follows. The chart below is the P/E multiple on trailing earnings.

As previously stated, we currently stand at a multiple of about 17x, which we’ve shown with the red line in the chart. The average P/E multiple since 1871 is roughly 15.5x trailing earnings, so on this metric the S&P is still roughly 10% overvalued. However, as you can see in the chart above, the period of the late 1990s was unique in this ~140 year data set. If we strip out the post-1998 period of crazy valuations, the average P/E multiple from 1871-1997 is around 14x, making the S&P about 15% above fair value even after the recent correction. Looking at the chart, the current multiple seems to be more consistent with peak valuations. High valuations can be interpreted as a vote of confidence in the future, so we are somewhat puzzled as to why investors are willing to pay such a high multiple during a period of such high uncertainty, when total debt to GDP is at 350%, the economy has been kept alive by government stimulus (that is now fading), the Fed has dropped short term rates to zero and ballooned their balance sheet, and so on. Valuations are fairly volatile over long periods, but they tend to be mean-reverting. There may still be some headwinds equity valuations, but at least it’s not 1999 anymore. Given the recovery in earnings, the March 2009 lows in the mid 600s for the S&P would represent about 10 times earnings, a much more attractive entry point (historically speaking) than the current 1100 level.

It hasn’t been a Lost Decade for everyone; the annualized total return on the 10yr Treasury since July 1999 is 6.8%.