How expensive are US equities? Fed Governor Lael Brainard warned about “stretched valuations” in the preamble to the May 2021 Financial Stability Report:
Vulnerabilities associated with elevated risk appetite are rising. Valuations across a range of asset classes have continued to rise from levels that were already elevated late last year…The combination of stretched valuations with very high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event.
An expensive market
Unpacking the equity risk premium
Many have been puzzled that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic and the economic downturn it has wrought. But with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.
The Excess CAPE yield compares the market’s CAPE to interest rates by calculating an equity risk premium (ERP) for stock prices.
Another way of calculating ERP is the Fed model, which is the market’s forward E/P minus the 10-year Treasury yield. Morgan Stanley found that the ERP calculated this way appears extended (top panel). If the analyst were to substitute the 10-year breakeven yield (because investors are more interested in real returns than nominal returns), valuations are comparable to the dot-com bubble top.
Does that mean the market is wildly stretched, even on ERP? Not necessarily. Aswath Damodaran, professor of finance at the Stern School, calculates his own ERP using a detailed technique explained in a long paper. Damodaran’s history went back to 1960 compared to Morgan Stanley’s 1998. Damodarn’s latest update on May 1, 2021 showed an ERP of 4.11%. This puts both the Fed Model (Morgan Stanley’s top panel chart) and Damodaran ERP at roughly 2009 levels.
Household equity holdings
No correct valuation
“A rich prisoner who possesses two thousand ducats but needs two thousand ducats more to repurchase his freedom, will place a higher value on a gain of two thousand ducats than does another man with less money than he.”
A, B, and C, each of whom has different starting wealth, required ending wealth, and time horizon. For the sake of simplicity, we’ll suppose each has the exact same view of a security’s future volatility and return, which are labeled as s and m in the figure.
When we place these three prisoners in the marketplace, we would expect Prisoner A and Prisoner B to sell their shares to Prisoner C at the price of 1/c until Prisoner C exhausts his liquidity or Prisoner A and Prisoner B exhaust their inventory. Then, the price drops to 1/b, and Prisoner A continues to sell to Prisoner B. From there, the price drops to 1/a, and Prisoner A would buy, but no one would be willing to sell.
Prisoner C is an enigma. Traditional utility models would not expect anyone to accept lower returns in response to higher volatility. But goals-based investors can be variance-seeking when their initial wealth is low enough. Behavioral finance characterizes their goals as “aspirational.” This is why people buy lottery tickets and gamble: Increasing the volatility of outcomes is the only way of increasing their chance of achieving life-changing wealth.
A very present example is our current regime of ongoing quantitative easing (QE) from central banks around the world. For investors befuddled by sky-high stock valuations, the difference between Prisoner A and Prisoner B is illuminating. They are exactly the same except for one thing: Prisoner B is wealthier today.
In general, then, this means that adding cash to financial markets creates investors who are willing to pay more for the exact same security. Conversely, when excess liquidity is drained from markets, prices should drop, all else equal, because investors with less cash today require higher returns. Thus line B moves back to line A.
Another key component of price: each investor’s relative liquidity in the marketplace. If enough aspirational investors, or Prisoner Cs, deploy their cash into a security market, prices can remain elevated or spike until their liquidity is exhausted. Sound familiar, GameStop?
A secular bull
The ‘60s comparison is compelling, especially now that we’re going to have higher capital gains taxes 4-5 years after a cut in income taxes. The parallel is the Kennedy/Johnson tax cut of 1964 followed by the Nixon tax hike in 1969. It was “guns and butter” back then. Now it’s Covid and a progressive capital-to-labor wave. The late ’60s had social unrest and a speculative frenzy in growth stocks—sound familiar?
In my view, our current inflation rate essentially mirrors where things were in the 1966-67 time frame, before inflation really took off.
MMT argues that governments create new money by using fiscal policy. According to advocates, the primary risk once the economy reaches full employment is inflation, which can be addressed by gathering taxes to reduce the spending capacity of the private sector. MMT is debated with active dialogues about its theoretical integrity, the implications of the policy recommendations of its proponents, and the extent to which it is actually divergent from orthodox macroeconomics.
More than anything else, this probably explains larger differences between the Obama and Biden approaches. President Barack Obama operated in a world in which deficits mattered politically. Biden doesn’t. Between the unfunded Trump tax cuts and a year of hog-wild pandemic spending, politicians have largely given up even pretending that they ought to pay for things their constituents want; it’s no longer even a good cudgel with which to beat the opposition when you’re out of power.
- The equity bull has a long way to run.
- The cyclical recovery is bullish for value-oriented and cyclically sensitive sectors like financials, industrials, consumer discretionary (excluding high flyers like AMZN and TSLA), energy, and materials.
- Secular growth in green infrastructure is poised to benefit mining (see A “value” industry that’s about the be the “Next Best Thing”). While China still makes up the lion’s share of commodity demand, countries with carbon-neutral ambitions constitute 76-95% of industrial commodity demand.
- Balanced fund investors need to be prepared for greater volatility and re-think portfolio construction in an era of rising bond yields (see 60/40 resilience in an inflation age).