Valuations continue to reach new highs, and the market looks very expensive—by some measures, the third highest of all time after 1929 and 1999. Meanwhile, the economy is showing signs of slowing. I have made my own views about what might come next pretty clear, but it’s worth taking the counterarguments—that current stock prices are reasonable, not a cause for concern—seriously as well. I say this all the more because analysts I respect are increasingly positing that it is different this time. So let’s see if we can make a case for that.
The argument for current stock prices
The fundamental economic argument that current stock prices are reasonable is based on low interest rates, but there are actually two threads to this argument:
- That lower rates are here to stay
- That the equity risk premium has declined
Lower rates here to stay. Rates are driven by central bankers, and many analysts believe they will continue to keep rates low. In this kind of environment, the argument goes, there really is no alternative to stocks, so investors have to keep buying.
Put in a more analytical way, when bond rates drop, the required return on stocks should drop as well. Stock prices are calculated using a required return that consists of a base of bond rates, plus a return required to compensate for the greater riskiness inherent to stocks. When the base drops, so should the required return. A lower required return means buyers will pay a higher price—and there you have current valuations.
This makes sense, and we’ve arguably been watching this scenario play out over the past several years. Mathematically, it is irrefutable. It assumes, however, that lower rates are here to stay, and I have a problem with that. Historically, economic recoveries have generated higher interest rates, and when rates rise, by the same logic, stock prices should fall.
If rates were to stay at current levels, then that would mean that economic growth had not kicked in. As we have seen recently, rates can stay low during slow-growth periods, and this would justify current stock valuations. But slow economic growth would also likely hamper corporate earnings growth. The higher valuations we get from lower interest rates would be offset by lower valuations from slower growth. This is the contradiction inherent to the argument that lower rates justify higher valuations.
Declining equity risk premium. The second way to square the circle is to argue that the risk premium associated with stocks—which is the extra return investors demand for the risk of holding them—has declined, and that’s why current valuations are high. The equity risk premium, or ERP, is not actually observable, but it can be estimated by calculating the spread between the actual returns of stocks and bonds of various sorts.
Looking at the historical data, whether the ERP has declined or not depends on what your base is. Using Treasury bill interest rates as a base, the observed ERP has actually risen over the period from 2007 to 2016, as compared with the period from 1967 to 2016. But the ERP has declined over the same period using Treasury bond rates. So, the argument that the ERP has declined is inconclusive, based on historical evidence.
Similarly, looking at investors’ expectations today, you can see that, on the whole, they are confident. That usually correlates to higher return expectations, not lower, and it certainly doesn’t suggest that investors are willing to be paid less for stock risk. Surveys suggest they actually expect to make more, so I don’t think current high prices are supported by investor willingness to expect lower future returns.
The two major arguments that this time is indeed different therefore have some structural inconsistencies baked into them that make them unlikely to hold up over time.
What if I’m wrong?
Mind you, I could be wrong, so let’s think about what would happen if that were the case. If rates remain low, then growth would likely also be slower than historical levels, which would ultimately reduce valuations. Current valuations have largely come from investors expecting growth to pick up. What if we move into a recession instead? Expect valuations to drop, as they always have. Or, if investors expect returns to be lower, and bid up prices, then aren’t they likely to be right? One of the best predictors of future returns is the initial price paid, so this becomes a self-fulfilling prophecy.
Any way I look at it, things are very probably not different this time, and even if they are, that does not provide a great deal of encouragement for the markets over the next several years. Try as I might, I still end up back at my original concerns.