I don’t often re-post other content, but the piece (link in full below) is worth sharing. It is a “where are the markets now?” piece that very tidily sums up the main (credible) arguments for over or under-valuation of financial markets. It is readable, clear enough for a non-expert reader to follow the gist, and balanced. In other words, something I wish I’d managed to write myself.
I agree with his conclusion with a similar dose of caution. Equity markets simply aren’t looking all that overvalued although we could collectively frighten ourselves into a sell-off regardless.
A few points that really stood out for me.
- Interest rates are low, but central bankers have had only a secondary role.Conspiracy theories are always difficult to confront, but at the heart of this one is the belief that central banks set interest rates, not just influence them at the margin. But is that true? To answer that question, I will fall back on a simple measure of what I call an intrinsic risk free rate, constructed by adding the inflation rate to the real growth rate, drawing on the belief that interest rates should reflect expected inflation (rising with inflation) and real interest rates (related directly to real growth). Looking back over the last decade, it is low inflation and anemic economic growth that have been driving interest rates lower, not a central banking cabal. It is true that at the start of October 2019, the gap between the ten-year treasury bond rate and the intrinsic risk free rate is higher than it has been in a long time, suggesting that either Jerome Powell is a more powerful central banker than his predecessors or, more likely, that the bond market is building in expectations of lower inflation and growth.
- Stocks are richly priced, relative to history, but not relative to alternative investments today
If you are convinced by one of the arguments above that stocks are over priced and choose to sell, you face a question of where to invest that cash. After all, within the financial market, if you don’t own stocks, you have to own bonds, and this is where the ground has shifted the most against those using the mean reversion argument with PE ratios. Specifically, if you consider bonds to be your alternative to stocks, the drop in treasury rates over the last decade has made the bond alternative less attractive. In the graph below, I compare earnings yields on US stocks to T.Bond rates, and include dividend and cash yields in my comparison:
In short, if your complaint is that earnings yields are low, relative to their historic norms, you are right, but they are high relative to treasury rates today.
- Though I have confessed to being a terrible market timer, the implied ERP [Equity Risk Premium] has become my divining rod for overall market pricing. An unduly low number, like the 2% that I computed at the end of 1999 for the S&P 500, would represent market over-pricing and a really high number, such as the 6.5% that you saw at the start of 2009, would be a sign of market under-pricing. At 5.55%, I am at the high end of the range, not the low end, and that backs up the case that given treasury rates, earnings and cash flows today, stock prices are not unduly high.