Equities: Rational Exuberance

by: DoctoRx


Many wonder if the US stock market has reached peak valuation and peak exuberance.

Short-term setbacks are always very possible, especially after 14+ straight "up" months.

Yet there is a coherent top-down argument that suggests that while equities are "high," they are less high than most alternatives.

With good economic data ongoing, this article makes the quantitative case that stocks could continue providing alpha versus the alternatives.


The adage to not look a gift horse in the mouth relates to checking the quality of the gift, or the oral health in this specific case. By analogy, ongoing bullish, trending stock markets can be accepted which understanding that nothing is perfect. But the evolving evidence is that this one is almost as good as it gets, but that history suggests there is no reason to panic and expect an early catastrophe requiring a major retreat from market exposure. Here's my reasoning.

Broad advance

The NYSE cumulative advance-decline line has been trending upward for years. This includes both the number of stocks and the volume. Ed Yardeni's latest post documents this.

In 2007-2008, the downturn in the A/D line for number of stocks rising/falling turned down many months before the ultimate top in the S&P 500 (SPY).

While I cannot find a long-term chart of this parameter, a review of Value Line data suggests that the A/D line peaked at the end of 1997, years before the final peak of the SPY, DJIA (DIA) or NASDAQ 100 (QQQ).

In other words, the bull market is recruiting more participants, broadening the advance from tech and other growth stocks.

The 2008 experience is that the strongest stocks stay strong even after a recession begins. In the absence of recession, of which few see a clear sign, the next section discusses why the Goldilocks scenario for the markets can hold sway.

Goldilocks slumbers on

Before the Tech Wreck of the early 2000s, the 'Goldilocks' scenario described an economy that was not running too hot but also was not cold (i.e., no recession in sight). This was just like the porridge in the children's story: just right. Translated to financial market action, Goldilocks markets allowed corporate sales and profits to rise at an acceptable pace, while the economy was on track to produce only moderate inflation, say in the 3% range. This low inflation (for the time) allowed interest rates to trend down after their extreme 1974-1984 peak levels. This downtrend in rates in turn allowed P/E expansion. So there was a virtuous cycle: just right.

This scenario of good economic growth with acceptable inflation may be underway again, though with a bias to the other direction: a renormalization of interest rates to more fairly rewarding savers, i.e. versus higher real rates.

Strong economic growth could occur without high inflation. One reason is that "good" growth is not inflationary. More people working, if they are producing more goods and services than the value of their compensation, can lower prices for those goods and services, not increase them.

We are seeing much faster growth in the labor effort provided in the United States than the secular stagnation theory allows for. In the most recent BLS employment survey, aggregate weekly hours rose from an index level of 106.2 in December 2016 to 108.3 in December 2017. That's a 2% yoy increase. However, the Economic Cycle Research Institute, or ECRI, has been banging the drum for years that the US was trapped in a secular stagnation in large part because labor force growth was doomed to be only 0.5% or so. Wrong! The US has experienced 15 years of below-trend GDP growth, which has led to underutilization of labor resources. People are rejoining the labor force, workers are, in the aggregate, working more hours per person. Add in 1+% productivity gains, and it is easy to envision 3-3.5% real GDP growth. Then add 1.5-2% PCE inflation, which would be more like 2.5% CPI inflation, and one can have 5-6% revenue growth for businesses. At the same time, interest rates would not have room to fall, but steady inflation and demand from countries with even lower interest rates could keep rates relatively stable. Note that on Friday, the BLS has just reported December yoy CPI growth of 2.1%. So far, so good, and while 10-year rates are up a bit on the news, the 30-year bond is unchanged. Goldilocks slumbers on in bond - land...

This could then lead to the following ongoing paradigm that is friendly for equities:

Rational exuberance for equities

Here's the paradigm that could be developing and which could have a long way to run. This paradigm involves confidence that via the many strengths of the US economy, plus an ironclad commitment to print money (electronically) as needed to prevent deflation, there is only one basic direction for GDP: up. Thus, corporate sales and profits will follow; even if there is a disturbance in the ether, it will be temporary.

In that way of thinking, an irregular but upward path of earnings will accrue to market participants, especially in an index comprising systemically important companies, i.e. the SPY or DIA. Although one does not receive all earnings right away as dividends, in financial theory, the owner of the business does receive them when earned. Thus it is rational to compare the yield on those earnings to yields on other investments. If post-tax reform the SPY is expected to earn $140 this calendar year, then a 2800 S&P level would be 20X forward earnings and its earnings yield would be 5.0% from that level (reciprocal of the P/E). Now one gets to the forward forecast. Under the secular stagnation hypothesis, one could think about the Japan scenario of zero nominal GDP growth for 20 years. In that case, a 5% earnings yield is unattractive, as it could drop if profit margins drop as sales stay unchanged.

But under a New Normal of a return to historical nominal GDP growth, investors can rationally think that in 10-12 years, earnings will double, meaning that this year's projected 5% earnings yield will be 10%; and then 20% in another 10 years.

Meanwhile, the fixed income investor has the opportunity right now of locking in 4% or less on an Apple (AAPL) bond that matures in the mid-2040s, more than 20 years from now. Or, a 2.9% yield on a Treasury that matures in 2047.

What is the "right" P/E, or earnings yield, for AAPL shares given the alternative of getting paid close to 4% per year from AAPL for the next nearly 30 years? All I can say is, I'm happier with the stock, and think it is undervalued versus the AAPL fixed income alternative.

Moving beyond one specific stock to the SPY or DIA, there is no way of knowing which paradigm will prove more accurate; over the course of the next 10 and 20 years, there may well be multiple other ways of valuing securities than the one I forecast in this article. But, for now, I can argue that stocks could be priced much higher, right now, than they are, for corporate bonds (or Treasuries) to be as attractive for long-term investors.

This approach was used and taken to excess in the 1990s.

Briefly, a trip back to that era.

The essence of how the '90s overdid the exuberance

The SPY began the year 2000 at a 29X P/E, having begun 1999 at a 32X P/E. By the first half of 2000, Treasury interest rates were above 6% up and down the entire yield curve. Thus, corporate bond rates were above 7%. Thus, forward earnings yields were half or a bit less than half the yields available from corporate short-term notes or long-term bonds. The result was soon trouble for stock prices even without the recession that began in 2001, and a drop in interest rates.

Markets today are so far from that era's irrational exuberance (overpricing) of stock prices versus alternatives that there is now lots of room for equity prices to trend up, assuming interest rates do not skyrocket, before even approaching prior relative levels when compared to other financial instruments.

Finally, unexpected sources are satisfied with tax reform.

Listening to non-Republicans for reviews of tax reform

Political ramifications and criticisms aside, some of the commentaries on the recent tax bill surprised me. From Bloomberg News:

ECB Says Trump's Tax Cuts Will Aid Euro-Area Economic Boom

The euro-area economy may get a boost from an unlikely ally: Donald Trump.

The currency bloc's expansion is the strongest in a decade and could be lifted further by the U.S. tax reform, according to the account of the European Central Bank's December policy meeting published Thursday...

More from Bloomberg, referring to Blackrock's (BLK) CEO, a Democrat, Larry Fink:

The stimulus created by the tax reform is likely to drive more money into investment products and push stock and bond prices even higher. Fink said in an interview with Bloomberg that the tax law will give clients more cash flow, which can be used for making investments.

"We're seeing clients continuing to put money to work," he said. "I expect that to continue."

And, finally, directly from Bloomberg News, remembering that Michael Bloomberg, who spoke at the DNC convention in favor of Hillary Clinton, an acknowledgement that the tax bill was not really much of a 'war' against 'blue' states:

Trump's Tax 'War' May Not Be as Bad as the Blue States Think

In liberal bastions like metro New York and California, the Trump tax overhaul has been criticized as economic warfare.

But as elements of the plan come into focus, tax experts are concluding that some of the most dire predictions for high-tax blue states - particularly surrounding the treatment of state and local taxes - may not pan out as feared.

In blue New Jersey, for instance, the new law will raise taxes on about 285,000 filers earning between $79,890 and $336,620, with a typical hike of about $1,400, according to an analysis by the liberal Institute on Taxation and Economic Policy. However, more than 1.2 million New Jerseyans in the same income range will get a cut, with typical savings of about $3,000, according to the analysis.

So, ignoring predictions from the party that passed the legislation, the above sort of analyses, either from the ECB or non-Trump supporters leaves me thinking that the consensus of a 0.4% increase in GDP due to the tax bill is a sensible prediction. And, since it is "growthy," and increases the federal deficit, it pushes investor psychology away from fixed income at today's low rates and toward equities.

The tax bill and realities it engenders, along with the psychology it is bringing with it, is for now outweighing negative psychology that could relate to the ongoing process of reversing QE; though, the latter is still early and immature.


What this article lays out is a set of expectations and assumptions both about the US economy and interest rates, and how investors may react to those variables. The future is almost always different from that which we envision, and one of the reasons to stay on top of one's investments is that if the underpinnings of an investment philosophy change enough, significant changes in one's savings, or those of one's clients, may need to be made, sometimes quickly. In other words, nothing is guaranteed and stocks could easily be cruising for a bruising for years to come.

Concluding thoughts - a way of understanding this bull

The Great Recession ushered in the era of widespread "money printing" via "quantitative easing," or in Japan, quantitative and qualitative easing, i.e. QQE. Whether one thinks of QE or QQE, now that central banks and the governments they serve can point to a strong global economic expansion, I have no doubt that if something even close to a second Great Recession moves into view, these sorts of policies will be regarded as traditional, good things to consider doing. In that setting, remembering that during QE periods, it was "risk on" with higher interest rates during periods of bond buying, there is little reason right now to revert to the older idea of an equity risk premium to bonds. Rather, one may wonder if it is bonds that deserve a premium to stocks. That's why I simply compare yields on corporate debt instruments to earnings yields from the same companies head-to-head, giving neither equities nor fixed income a risk premium.

In conclusion, I reject not only the idea of secular stagnation, but I also reject the idea that the financial markets can be analogized to a baseball game with "innings." The truth is plain to see: the markets go on forever, unlike a game with a starting point and rules for its ending. We simply travel along on the journey of the economy and the financial instruments that both derive from it and help shape it. Right now, it appears that the US and much of the global economy has awakened from its post-Great Recession healing process. From the standpoint of a US investor, there are too many similarities to the nearly uninterrupted good years from 1983-2000 to do other than look for the best way for exposure to equities and watch out for bumps or potholes in the road. When things are in gear, they tend to stay in gear for years. When given an investment gift horse of what looks like a virtuous cycle, maybe, indeed, it should not be examined too closely for flaws, and just ridden and enjoyed.

If so, with improving advance-decline lines, this may be a time where the SPY or other broad index is even a thinking investor's preferred vehicle. That's a different way I am thinking about markets, as opposed to such years as 2010, a year I pegged as a year for inflation assets, or 2014, "the year of biotech." Post-tax reform, which some uncertainties as to precisely how it will play out, and with growth in the EU and US, and apparently China and Japan again, maybe investors want to be closer to everywhere in the markets rather than taking a narrow-bore approach (just some thoughts, not advice). In other words, given its liquidity and low fees, I like SPY here though obviously is the market (more or less) and cannot provide alpha against itself.

Thanks for reading and sharing any comments you wish to contribute.

Disclosure: I am/we are long SPY, AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.