Why Stock Market Valuations are Not Justified by Low Interest Rates: Beware

Why Stock Market Valuations are Not Justified by Low Interest Rates: Beware, by John Hussman, who is a moderately prominent US fund manager and analyst.

It’s such a comforting, even satisfying assumption; the idea that “lower interest rates justify higher valuations.” The idea is one of the most basic principles of finance. Indeed, investors could consider it a law of investing. Except for the fact that it’s an incomplete sentence. Unfortunately, the convenience of investing-by-slogan, rather than carefully thinking about finance and examining evidence, is currently leading investors into what is likely to be one of the worst disasters in the history of the U.S. stock market. …

At present, the most reliable measures of U.S. equity market valuation — the measures that are best-correlated with actual subsequent market returns in market cycles across history — are 2.75 times (175% above) their historical norms. Given that depressed interest rates are matched by commensurately low U.S. growth rates, little or none of this premium is actually “justified” by interest rates. Rather, the S&P 500 is likely to post negative total returns over the coming 10-12 year horizon, with a likely interim loss in excess of -60%.

Moreover, even if the growth rates of nominal GDP, S&P 500 revenues, and other fundamentals were to literally double to historically normal rates, yet Treasury bond yields could be held 2.5% below their historical median for another decade, the combination would only “justify” a valuation premium for the S&P 500 of about 2.5% x 10 years = 25% above its corresponding historical valuation norms. We’re already 175% above those norms. There’s no way to make the arithmetic work without assuming an implausible and sustained surge to historically normal economic growth rates, a near-permanent suppression of interest rates despite a full resumption of normal economic growth, and the permanent maintenance of near-record profit margins via permanently depressed real wage growth, despite an unemployment rate that now stands at just 4.2%.

There’s little doubt that the general level of long-term interest rates should be markedly lower than historical norms. But that’s because prospects for long-term growth are also markedly lower than historical norms. Again, the problem is that this combination deserves no valuation premium at all. Expected future stock market returns would be commensurately lower even in the absence of a valuation premium. That’s just how the arithmetic works.

Today’s obscene market valuations are largely the result of a) ignoring the growth side of this relationship, and b) activist central bank policies that have repeatedly driven short-term interest rates to levels that create a mentality of yield-scarcity among investors; where they stop quantifying the effect of rates and simply decide that “there is no alternative” to blindly speculating in risky assets regardless of their valuations. That’s what created the mortgage bubble that ended in the global financial crisis, and it’s what has created the “everything” bubble today.

Interest rates have been set by bureaucrats rather than by the market since early last century. This is the main job of central banks: setting the price of the most important item in our transactions, namely money. (The central banks literally mandate certain overnight interest rates, and the longer dated rates follow suit. Though the bond prices are determined by free and open markets, the market has to guess what the central banks next edict will be.)

Having bureaucrats rather than the markets set prices didn’t work for the Soviet economy, and it’s not working for ours.

By the way, defenders of central banking point out that price setting theoretically ameliorates the ups and downs of the markets, which were wild before central banking. Not really. The ups and downs were due to fractional reserve banking, introduced into the West around 1700 — after being effectively banned for centuries by religious edict. Before 1700, there were no bubbles: the first big bubble was the Tulip bubble, in 1720.

Before 1700, interest rates stayed at a very steady 6%. Up until central banking in the 20th century, prices of goods remained basically stable for centuries, without significant inflation (though with more instability after 1700).

After a century of central banking, we have had massive and persistent inflation (a US dollar buys much less than 5% of what it could purchase in 1912) — and interest rates are now stuck at ridiculously low levels “to support the economy”.

No laughing matter if you are trying to live off savings. Retiring with a million dollars used to mean an interest income of $60,000 per year from low risk bonds, but as many retired folks today know all too well, it just ain’t so anymore. Blame central banks.

That scarcely anyone knows the role of central banks in creating this mess, or even where money comes from, is a testament to an early form of political correctness — it is politically incorrect to talk about where money comes from, or who benefits. (Ever notice that there are trillions of dollars around today, when even a couple of decades ago a billion dollars was a lot? Who made that money? For whom? Did you get any? Who benefits?)

When the markets revolt against the central bankers, as they inevitably will, the fallout will be massive. Many people who think they are wealthy will find out that they aren’t anymore. Money is essentially a promise of being able to buy in the future roughly what its purchasing power is today. But not all those promises can be kept — too many of them have been issued.

The amount of money sloshing around the world, compared to GDP, is way higher than it has ever been: the great monetary bubble of 1982 to 2007 saw the ratio of “money” (mainly bank credit) rise from its usual 100 to 150% to around 375%, where it has remained since. When it drops back to the usual level, all asset markets will plummet (with one obvious exception). In monetary terms it will be a double or triple Great Depression (which started from 200% and fell back).

The central banks are trying to stave off the inevitable with near zero interest rates, and some printing (“quantitative easing”). Eventually they will try to inflate away the debt to restore more normal money levels. It could take decades to play out (like in Japan, which entered this stagnancy in 1990), or it could be triggered by some unforeseen event and be over in a couple of years.

In the meantime, ever noticed how the mainstream media is utterly quiet about the foibles of banking and where they have led us?