So the mindset, I think, goes something like this. Yes, market valuations are elevated, but, you know, low interest rates justify higher valuations. Besides, there’s really no alternative to stocks because you’ll get what, 1% annually in cash? Look at how the market has done in recent years. There’s no comparison. Value investors who thought stocks were overpriced in recent years have been wrong, wrong, and wrong again, and even if they’re eventually right, being early is just the same as being wrong. The best bet is just to invest in a passive index fund for the long-term, and ignore the swings. There’s really no alternative.
What’s notable about this mindset is its excruciating reliance on three ideas. The first is that low interest rates “justify” rich valuations. The second is that market returns simply emerge as a kind of providence from a higher power, perhaps magical gnomes, or the Federal Reserve if you like, and that those returns have no particular relationship to valuations even in the long-term. The third is that market returns during the recent advancing half-cycle are an accurate guide to future outcomes.
The problem is that this argument is the exact essence of a bubble mentality. Specifically, the mindset boils down to the proposition that stocks have gone up, and though valuations have become rich, stocks have continued to go up, so valuations must not matter all that much. And even if valuations did matter, low interest rates “justify” extreme market valuations while simultaneously offering no alternative to stocks. So market valuations are obscene because stocks have to compete with interest rates, but apparently, interest rates can’t compete with stocks.
In effect, stocks are viewed as good investments because they have been going up, and the evidence that stock prices will go up is that stock prices have gone up. Every additional market advance makes stocks look even better, based on past returns. Indeed, the more extreme valuations become, the more convinced investors become that extreme valuations don’t matter.
And that’s why we’re all gonna die.
A few insights may help to deconstruct this mindset. First, if one is going to invest one’s financial future in the stock market here, it’s worth making at least a cursory study of 5, 10 or even 20-year growth rates in population, labor force, productivity, S&P 500 revenues, earnings, real GDP, nominal GDP, and virtually every other measure of fundamentals. That exercise will quickly inform investors not only that the growth rate of fundamentals has persistently slowed from post-war norms in recent decades, but also that the underlying drivers of growth (primarily labor force demographics and productivity growth) are now running at rates that are likely to produce real GDP growth on the order of just 1% annually over the coming decade, while even a sizeable jump in productivity would likely result in sustained real GDP growth below 2% annually.
Unfortunately, this has implications for how one responds to interest rates, because the argument that “low interest rates justify higher valuations” relies on the assumption that the growth rate of underlying cash flows is held constant. Any basic discounted cash flow analysis will demonstrate that if interest rates are low because growth is also low, then no market valuation premium is “justified” by the low interest rates at all. Indeed, if both growth rates and interest rates are x% lower than their historical norms, then even a historically normal level of market valuation would be associated with subsequent market returns that are x% below historical norms. No valuation premium is required to produce this result.
Unfortunately, the most reliable valuation measures we identify (those most strongly correlated with actual subsequent market returns) are about 2.5 to 2.7 times their historical norms here. Paying a valuation premium in this case simply causes prospective future market returns to collapse. While stocks are claims on a very long-term stream of future cash flows, their merits are too often evaluated on the basis of their recent behavior. The fact that investors often respond to low interest rates by driving valuations higher creates the illusion, while it lasts, that rich valuations are not only “justified” but completely inconsequential. Ultimately, prices are expected to go up, because prices are going up, because prices have gone up.