One camp argues that the market is dangerously overvalued. The so-called CAPE ratio—the price-earnings multiple for the market based on cyclically adjusted earnings averaged over the past 10 years—stands at over 25, well above its long-run average of about 15. Today's CAPE has been exceeded only during the market peaks of 1929, early 2000 and 2007.
Another group of forecasters are convinced that stocks are reasonably valued. The main competitors for stocks in individual and institutional portfolios are bonds. And yields on fixed-income securities are at all-time lows. Short-term interest rates are essentially zero, and the yield on the 10-year U.S. Treasury bond is only 2.4%. Investors seeking a reasonable rate of return have few places to go other than equities. This camp believes equities are a particularly attractive option in the menu offered by today's capital markets.
Burton Malkiel, author of "A Random Walk Down Wall Street" thinks there is merit to both camps:
If we add three or four percentage points to the current low Treasury yield, we still get a low discount rate that can justify high stock prices. And today's low interest rates may persist. The world is likely to experience a long period of abundant productive and labor capacity with attendant slow growth, along with low interest rates.
While continued low rates can justify high stock prices, the CAPE followers are correct as well. Long-run equity returns from today's price levels are likely to be considerably lower than their 10% long-run average.
He recommends diversifying, not trying to time the market. He seems like a buy and hold kind of guy.
ReplyDeleteON THE ONE HAND: It’s true that, on the one hand, low interest rates (low discount rates) make a stream of cash (like earnings from a company) more valuable.
ON THE OTHER HAND: There’s no limit to the number of companies that people can create and take public. If it costs $500 million to build a company and it will sell in the stock market for $800 million because of low interest rates, there’s an arbitrage there. In theory, so many new companies will be created and taken public that the public market price for them will come back down to $500 million. Low discount rates be damned.
The first is a “CAPE” analysis: earnings-based. The second is a “q” (as in Tobin’s q) analysis: replacement-cost-based.
My understanding of this is that replacement cost matters but that it’s a slow roll and that we can be out of equilibrium for a long time in terms of q…not forever but for a time that can feel like forever. Sort of like housing – even when housing gets really expensive, houses are so long-lived and hard to build rapidly that it takes a while to bring enough new supply on to matter much, price-wise.
This is truly the conundrum created by this administrations policy for recovery. By bringing rates to zero overnight and QE 1, 2 & 3 bringing the remainder of the curve down it has created asset bubbles because of lower discount rates. Furthermore, there has been a pretty explicit "Bernanke Put" or now "Yellen Put" that suggests should the market draw down a bit, have no fear the central bank will prop it up. As a result ERP is rather low. Also, look at 2013 sharpe ratio from the S&P... 32% with 11-12% vol. NUTS. As rates rise and the implicit put goes away what happens is a very good question. Those discount rates in all likelihood will rise (ERP's expand and Rfr will be higher).
ReplyDeleteI think it depends on why rates are rising. If it's because of improving employment and accelerating GDP (our base case) bonds struggle and equities can grind higher on EPS Growth and basically defend their current multiples. Net net - equities have a very modest mid-to-high single digit returns with materially higher vol. Fixed income generates 0 to negative returns. The challenge is, how do pensions meet hurdle rates and investors meet required returns for retirement if a 60/40 portfolio only projects to return a nominal gross of tax return between 3-4% for the next 3-5 years. With that said, I really think alpha is in this market (meaning the market isn't discriminating good vs. bad companies) and decisions like CALPERS to fire all alternatives right now is a really bad decision. Final thought, increased regulation and tier 1 capital ratio's has put the traditional liquidity providers (i.e. - market makers) out of business. Therefore, illiquidity premium is available. Why would you sell HF's and or P/E deals at a time like that? Makes no sense....
Equity Risk Premium and Mean Reversion
ReplyDeleteAccording to six well-known indicators1 of stock market valuation, equities are more overvalued today than in 69% to 89% of all bull-market peaks in the past century, with five out of the six indicators signaling above 80%. And although the indicators, which are expressed as ratios, each take a widely different approach to valuation, their results closely point to the same conclusion. Yet, the stock market may nonetheless still be attractively valued at the present time because of the spread on the risk premium2, which is relatively high due to low yield offers in the bond market. The authors of a New York Fed paper3 published last year concluded: “Our analysis provides evidence that is consistent with a bond-driven ERP: expected excess stock returns are high not because stocks are expected to have high returns, but because bond yields are exceptionally low.” Seems if all else remains unchanged, at the point when interest rates are raised the spread will narrow and the stock market will begin to mean-revert.
1Source: http://www.marketwatch.com/story/the-stock-market-is-overvalued-any-way-you-look-at-it-2015-01-13
2Source: http://seekingalpha.com/article/2297855-the-equity-risk-premium-is-still-high
3Source: http://www.newyorkfed.org/research/economists/duarte/Duarte_Rosa_EquityRiskPremium.pdf
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