In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases and the price of the equity asset should appreciate, assuming all other model inputs stay constant. So, interest-rate cuts by central banks may be used to justify higher equity prices and CAPE ratios. Thus, the level of interest rates is an increasingly important element to consider when valuing equities. 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.”

– Shiller, Black & Jivraj, Project Syndicate, November 30, 2020

The opening quote above seems almost obvious. That’s the problem. It’s actually a striking example of the insidious and exquisitely circular logic that I believe will prove disappointing and possibly even catastrophic for investors over the coming decade. What follows may help to clarify the situation.

Before going on, I should start by saying that I’ve got great admiration for Robert Shiller. Even three decades ago when I was completing my doctorate at Stanford, I avidly embraced his work, including his studies on excess volatility. He has originated an impressive range of useful tools, including the Case-Shiller housing price indices. As the tech bubble was peaking in 2000, I doubt that any 30-something in finance was more pleased to see Shiller become a widely-quoted figure in the financial markets. All of that is important to say, before I tear into this particular metric.

Frankly, I suspect Shiller lent his name to the Project Syndicate piece. His independent work is more careful, while his recent collaborations have increasingly read like apologetics for historically untenable valuations. I hope he will quickly call such loans due, lest they affect his otherwise remarkable reputation.

A security is nothing more than a claim to some future set of expected cash flows. The more you pay today for that stream of future cash flows, the lower return you will receive over time. Right now, bond market investors are paying just over $91 today in return for an expected $100 payment from the U.S. Treasury a decade from now. That works out to an annual return averaging nearly 0.9%.

Suppose you don’t like the idea of making less than 1% annually on your investment for a decade. Let me tell you something that’s absolutely true, and will make the investment in Treasury bonds seem vastly more attractive:

Yes, bond prices are high. But they’re fairly-valued relative to interest rates.

That statement might seem funny, if it wasn’t both a) the stupidest thing you’ve ever heard, and b) essentially the same argument that’s being made to justify the most extreme stock market valuations in U.S. history. Obviously, bonds are always “fairly-valued” if their own rate of return is used for comparison. But it’s such a circular argument that it lacks intrinsic meaning, and it’s certainly not what investors hear. What they hear, when someone says “fairly-valued,” is that investors can expect future returns to be somewhere in the range of historical norms, or at least historical experience. That’s not what’s being said at all.

What’s actually happening today is that investors are so uncomfortable with near-zero bond market valuations that they’ve priced nearly every other asset class at levels that can be expected to produce near-zero, or negative, 10-12 year returns as well.