By Rob Bennett
A community member who goes by the screen name "TheShoeHorn" made an interesting point in a comment he posted a few weeks ago to one of my columns here. I was, as usual, making the case that investors need to pay more attention to valuations when making asset allocation decisions. TheShoeHorn argued that: "Shiller's model desperately needs to factor in rates." He pointed to an observation made by Warren Buffett that, if interest rates stay below 3 percent, higher valuation levels for stocks make sense. According to TheShoeHorn: "The choice investors have to make is a simple weighing up of what you can get from one asset class vs. another."
In a follow-up comment, TheShoeHorn argued that: "When bonds have an effective PE of 100 (as they do in much of Europe), and inflation is only 1%, you'd happily hold stocks on CAPE ratios of 50 (earnings yield 2%), because that's the only way to make a positive return in that market. And if the market stayed like that, stock valuations would creep up to CAPE 100 perfectly rationally." Again he cited Buffett, quoting him as saying: "In a world where investors knew interest rates would be zero 'forever,' stocks would sell at 100 or 200 times earnings because there would be nowhere else to earn a return."
The point being made is a powerful one. I certainly agree that investment classes cannot be assessed in isolation. It drives me crazy that most experts in this field were advising investors to go with high stock allocations in 2000, when the P/E10 value was so high that a regression analysis of the historical return data showed that the most likely 10-year annualized return on stocks was a negative 1 percent real and when Treasury Inflation-Protected Bonds were offering a risk-free return of 4 percent real for time periods of up to 30 years. Some of the articles that I read in those days made me want to scream at my computer screen. An investor who moves $100,000 from an investment class paying a return of a negative 1 percent real for 10 years to an investment class paying 4 percent real for 10 years is ahead at the end of that time by $50,000. 50 percent of his initial portfolio value. Why don't we all make more of an effort to get the word out on things like this?
It is of course true, however, that investors are not today able to purchase risk-free assets paying a long-term return of 4 percent real or anything close to it. And it is also true that no asset class can be effectively assessed in isolation. If stocks offer a better return than other available asset classes, then stocks are the best choice, no matter how high valuations are at the moment. I cannot argue with the logic being advanced by my new friend TheShoeHorn (and, indirectly, by the grandmaster of valuation-informed investing, Warren Buffett).
Still, I have a hard time accepting the idea that stocks can offer a strong long-term value proposition when the P/E10 level stands where it stands today. Is there a flaw in the case being made by TheShoeHorn?
One basic concern that I have is that a sky-high P/E10 level is telling us that investors are not acting rationally. It is rational to prefer stocks to bonds when interest rates are so low that bonds barely offer a positive return. But if we are to accept that an exceptional investor demand for stocks makes sense when interest rates are at rock-bottom lows, we are left with the question as to why interest rates are at rock-bottom lows.
There's something weird going on in the overall market (the one in which stocks compete with bonds and other asset classes for the hearts and minds of investors). It worries me that that is the case. I don't feel comfortable saying, "Oh, those sky-high stock prices are okay so long as interest rates are just as crazy." I would prefer to live in a world in which both interest rates and stock prices were at sensible levels. And it doesn't seem to me that we are in that place today. It doesn't entirely alleviate my concerns for me to conclude that the craziness of today's stock prices doesn't look so bad when considered in relation to the even greater craziness that applies in the bond market.
Here's a thought. Stock prices fell very hard in 2008. That obviously caused a huge loss in consumer buying power. There was talk in serious financial publications that it was possible that we might be headed into a second Great Depression. But stock investors were reassured, and valuations headed back upward and the economic crisis eased. Could it be that the Federal Reserve is concerned over the possibility that stocks might crash again and is reluctant to let interest rates increase because it wants to provide the stimulus to stock-buying to which TheShoeHorn is referring?
Is it possible that our failure to address the sky-high stock valuations that have applied for over 20 years now has put us in a spot where either the negatives associated with low interest rates or the negatives associated with high stock prices are locked in? I find the logic chain described by TheShoeHorn troubling. Yes, investors are being rational to choose even high-priced stocks in circumstances in which alternatives offering a decent return are not available. But why aren't alternatives offering a decent return available? Can we identify the driver of the low interest rates?
I often make the point that Shiller "revolutionized" (he uses that word in the subtitle of his book) our understanding of how stock investing works with his 1981 finding that valuations affect long-term return. The breakthrough discovery was that it is shifts in investor emotion that set stock prices, not investors' rational pursuit of their self-interest. I am wondering (that's all I am doing here, it is not my intent to speak dogmatically regarding these matters) if the craziness that we have evidenced as investors from 1996 forward found its way into the bond market in the days following the 2008 crash, when the Federal Reserve felt forced to take steps to stop the economic destruction that was resulting from our collective decision to try to send stock prices back to levels somewhat closer to those that are generally perceived as healthy and normal.
I am grateful to TheShoeHorn for advancing the point he made in his comment. It was a thoughtful one that I believe all of us who worry about the valuation levels that have applied in recent years should be pondering today.