Could the underperforming Capital Asset Pricing Model be replaced by a new, shinier model? Cormac Lucey examines the theoretical contender – the Holistic Market Model.
For decades, the Capital Asset Pricing Model (CAPM) has been the foundation stone of modern financial theory. Its cost of capital formula is routinely used to estimate the corporate cost of capital. And that, in turn, is used to value companies. It lies at the base of the architecture of asset allocation models and “efficient frontiers” that dominate investing today. The trouble is that the CAPM doesn’t work very well. Actual returns bear only a limited relationship to the CAPM’s predicted returns.
The CAPM is a bit like a banger of a car that is still driven by an impecunious student. They don’t drive the car because it’s any good – they drive it because it’s the only car they’ve got. Modern finance sticks to the CAPM even though it isn’t very good for the simple reason that it has nothing better to put in its place. But that may be about to change.
Jacques Cesar of the consultancy Oliver Wyman has spent the last five years working out an alternative to the CAPM. He and his firm have introduced the Holistic Market Model (HMM), which they describe as a radically inclusive blend of finance, accounting, analytics, economics, history, and sociology that explains the stock market’s past performance and frames the future. The HMM involves rejigging several key finance variables.
Earnings
The HMM moves EPS (earnings per share) from GAAP to what are called “Buffett earnings”. This refers to the surplus that can be distributed to shareholders once all reinvestments needed to keep the business going have been made. When Cesar applies a cyclical price-earnings multiple to the revised earnings numbers, the market is revealed not to have been as extremely cheap as it appeared in the 1970s and 1980s, and not as expensive as it appears now.
Discount rate
Cesar comes up with a Really Truly Risk-Free Rate (RTRR), which is the current risk-free rate converted into real terms by subtracting inflation expectations. It also removes what Cesar calls a “Treasury Risk Premium”, which reflects changes in the incentives to buy bonds.
Equity risk premium
Cesar reckons we can account for almost all differences in the equity risk premium (and therefore all variation in the valuation put on stocks relative to bonds) using five factors: first, business cycle and sub-cyclical variations in economic and financial risk – a quantitative risk-aversion indicator shows where market crashes will happen; second, inflation falling outside the ‘Goldilocks’ zone – extremes of inflation and deflation cause problems for equities; third, intergenerational increases in risk aversion driven by long secular bear markets (like the one from 1929–1942); fourth, “imperfect risk arbitrage between equities and Treasury bonds” – the equity risk premium tends to be even higher than it should be when the RTRR is extremely low, like it is today; and fifth, a factor that explains periods of speculative excess.
Supply and demand for equities
Recent decades have seen ageing populations and increased inequality in the developed world, both of which have sustained increased demand for equities. Model the moves in supply and demand for equities successfully, and you can capture an important influence on share prices. Oliver Wyman is now publishing a series of detailed research papers explaining and validating its analysis. Key questions that the model poses for the next decade are: whether the four-decade decline in the RTRR will be reversed; whether inflation will remain in the Goldilocks zone; and whether a change in the regulatory regime will put pressure on corporate profit margins.
Maybe the world of finance is about to get a theoretical car it likes driving, as opposed to one it has to drive for lack of a better alternative.
Cormac Lucey FCA is an economic commentator and lecturer at Chartered Accountants Ireland.
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