This post was originally published on this site
OK, there is no “permanently high plateau.” But the market’s valuation is structurally higher and it might never revert to its historical average.
Any number of people worry about the elevated valuation in the US stock market today. Probably you have seen this chart, of Shiller’s CAPE:
It shows that the trailing 10-yr average P/E (cyclically adjusted P/E, or CAPE) for the market is now at 30, while the long-term average for this number is 16.8. The Chicken Littles of the financial world – these would include Professor Shiller himself – predict a reversion to historical P/E averages. If that happened tomorrow, the market would get cut almost in half.
Are we standing on the brink of a valuation apocalypse? I don’t think so. The first clue is that above-average CAPE ratios have lasted twenty years, through two very severe market crashes in 2002 and 2008, only touching the long-term averages at the depths of the financial crisis. If that’s what it takes to revert to the mean, how likely is it that the market is going to sit there during a normal economy? It won’t. The valuation ratios of the market have become structurally higher, for two good reasons.
Reason 1: Bonds are valued much higher.
Stock market dollars have to compete with other uses of those dollars, particularly other asset classes. Of these, the most obvious are bonds. As bond interest rates rise, money tends to rotate from stocks to bonds, pushing down stock market valuations. As rates decline, money tends to rotate from bonds to stocks, raising market valuations. (Another way to think of this: the E/P ratio, P/E upside down, is the “interest rate” on the stock market. It moves in the same direction as the interest rates of the bond market.)
Interest rates have been in a secular decline since 1980. But “interest rates have been declining” is the same thing as “bond valuations have been rising.”
The Chicken Littles rarely declare that bonds are in a generation-long bubble and must mean-revert. They won’t because the Fed is determined to keep inflation at or below 2%. Also, there is some evidence for “secular stagnation,” a structural productivity slowdown in the economy. If the economy can’t produce wealth as quickly, interest rates can’t be as high as they used to be. But since stocks and bonds compete for investment dollars, stock market valuation won’t come under real pressure until interest rates rise significantly higher than they are today.
Reason 2: The stock market has become less risky.
No, don’t laugh, I’m serious. There are three ways we are in a different, less risky market than most of stock market history. But why does that matter?
Everybody knows that, over long stretches, stocks have returned more than bonds. Why this “equity premium” exists is a puzzle: in an efficient market, differences in asset returns should get arbitraged away. The usual explanation is that stocks are riskier than bonds. Nobody likes risk, so investors require a higher return to hold stocks. The riskier they are, the more return is required – i.e. the lower the valuation investors will demand.
It follows that if the market becomes less risky, investors will be willing to invest at higher valuations. And they should be: why not, if there’s less to go wrong?
A. Easy diversification
What is risk? Academics tend to think of it as volatility. Market participants tend to think of it as the chance of permanent loss of capital. You might think of it as some of both.
Either way, diversification helps: holding a S&P 500 index fund is way safer, we’re constantly told, than holding five or ten individual stocks.
Now consider what it used to take to hold a diversified portfolio of 500 large stocks. At the beginning of 1972, IBM was trading at 333 per share. You had to buy a round lot of 100 shares, and you had to pay the broker a 3% commission. So you had to put down $33,300 to hold one stock and you had to pay $1000 for the privilege. Even if you had the large fortune it would take to own 500 companies, you would spend a small fortune building the position.
As a result, nobody was “diversified,” in today’s terms, in 1972. Today, you can hold a portfolio of every stock in the market for 18 basis points, and most people do. Look how diversification has taken off since 1980 – not coincidentally, the period during which Shiller’s CAPE began to permanently elevate.
What was risky in 1972 is now much safer. (Not safe, but safer.) It’s perfectly logical, then, that the excess return investors demand for stocks has declined. As a result, valuations are structurally higher.
(Hat tip: I learned this point from “Jesse Livermore” of Philosophical Economics. His much longer and more detailed post is here.)
B. A more efficient market
The market is more efficient than it used to be.
At the macro level, more money is run by “smart” professionals, and less is run by “dumb” mom and pop money. (That would be me.) Mom and pop, for the most part, let Vanguard do its investing these days. The fierce competition for alpha has made it harder to come by, and fewer and fewer professionals are able to earn their keep picking stocks. The less talented have to drop out, leaving marginal prices to be set by ever-savvier investors.
At the micro level, the rise of the algos – many of which trade mean-reversion strategies – keeps small wiggles out of the market (and has helped depress the VIX).
A more efficient market is a less volatile market, more closely tied to fundamentals, less subject to swings of fear and greed. But a less volatile market is, by one prominent definition, a less risky market. (Not a riskless market. But less risky.) When risk declines, valuations rise.
C. The Fed put
It used to call this the “Greenspan put.” Then the “Bernanke put.” Now the “Yellen put.” I’ll just call it the Fed put. Regardless of who chairs the Fed, many people have the conviction that when the market hits a sharp decline, the Fed will step in and prop the market up. (The intelligent view is not that the Fed acts in order to prop up the market – the Fed is worried about the economy, not stocks – but that its actions have the effect of propping up the market.) The propping happens through lowering of interest rates, normally, with the QE maneuvers in the aftermath of the financial crisis being an extraordinary case.
When the Fed lowers interest rates, that’s the same as raising bond valuations. Those higher valuations transmit over to stocks, too.
When the Fed launched its QE program, a lot of people cried, “It will cause inflation!” Well, no inflation to speak of has arrived. But if you understand how QE works, you realize that the first thing to inflate is asset prices, with consumer price inflation relatively far down the chain of effects.
During QE, the Fed printed a lot of cash and used it to buy bonds. The extra demand for bonds drove down interest rates, which was the point. (In other words, it raised bond valuations.) Bond investors were now getting paltry yields, so some of them traded their bonds for stocks. This surge of demand for stocks raised stock valuations. You don’t get consumer price inflation until someone rotates from stocks and bonds into employee wages, Fords and ground chuck. But so far that hasn’t happened, and the “inflation” has stayed in asset prices. Asset prices won’t “deflate” until the people who hold assets – that’s institutions and the wealthy – find something they would rather spend their money on.
The Fed can keep interest rates low as long as it likes, and print as much money as it likes. As long as the Fed put is in place, there is a floor of sorts under asset prices. Not to say that the market can’t decline significantly. But it isn’t going to lose half its value without the Fed stepping in, and that makes the market less risky than it used to be for investors. And that is another reason they are comfortable accepting higher valuations (and lower future returns) on their money.
Where we are
It’s important to my argument that the market doesn’t just appear to have less risk. It actually has less risk. Diversification lowers risk, and it’s much easier and more common now. Professionalism lowers risk. The Fed lowers risk too: in central banks around the world, measures like QE that once were merely theoretical have become working tools. In Japan, the central bank just directly buys stocks – talk about propping up the market!
Similarly, interest rates are structurally, not temporarily, lower. Interest rates might climb a few points. But we’re not going to see 1980s-level rates at least until the present generation of Fed governors has died off.
The Shiller CAPE might hit 16.8 again, in recessionary conditions. But that isn’t going to be the average, normal P/E of the US market anytime soon. I would guess – guess – the normal level is somewhere around 20-25. That makes the present market toppy but not ridiculous.
Stock market valuations are higher than the historical average. They have been for twenty years. They will be for the next twenty years. And the sky is not falling.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.