It IS Different This Time: Context And The Valuation Of Stocks, Part 2

by: The Social Scientist.

A previous article argued that for the past 30 years stock valuations as measured by Shiller's PE10 have been greatly elevated.

This is because of contextual changes, that cannot be measured as variables.  These have changed the relationship between stock prices and earnings per share.

Contextual changes include the baby boomer bulge, newly legislated savings vehicles for retirement, the legalization of corporate buybacks, QE, increased industrial concentration, and higher percentages of private capital investment.

In my previous article, I made the case that since 1985 stocks have been valued much more highly on average than before 1985. That is, Shiller’s PE10 has been much higher on average for reasons other than corporate profit growth rates, interest rates, and inflation. The relationship between the level of prices and 10-year averages of earnings per share has changed. There is no variable or variables to explain the change in relationship. I think it is a result of a combination of events that I call context. Some of these events are identifiable. Other events may have occurred already that we do not yet recognize as a contextual change. By going through some contextual changes that I think have changed the relationship between stock prices and earnings, I will illustrate what I mean by context.

Technological change is not a contextual change that influences the valuation of stocks independently of other influences. Technological change increases stock prices, but it does so via economic growth and increases in corporate profits. It has increased industrial concentration, however, which has increased stock valuations. This is discussed below.

Between the mid-1960s and 1973 the US went from being self-sufficient in oil to becoming a major oil importer. As a result the US discovered in 1973 that it had lost control of oil prices to OPEC and the Middle East. The loss of control of oil prices is a contextual change for other relationships, but not for stock valuations. This event affected inflation, which in turn has affected interest rates, and therefore stock valuations are affected, but the relationships between stock prices and inflation rates and stock prices and interest rates were not necessarily changed.

Total private debts as a percentage of annual GDP and public debt as a percentage of annual GDP are measures of debt levels that enable temporal comparisons of debt levels, to ascertain whether debt levels in the economy are high or low. Debt levels seem to be a cyclic change in context as is income inequality. Private debt levels and income inequality were both high in the late 1920’s, and also during this century. The distinction between private and public debt really matters, because governments, which control their own currency, cannot go bankrupt if their debt is denominated in their own currency.

Elevated private debt burdens should depress stock prices, which has not occurred, although that may yet happen. On the other hand, high debt levels may contribute to low interest rates for many years to come, which should help stock prices. Whether debt levels are a contextual change, depends on whether the relationship between interest rates and the valuation of stocks has changed.

Increased income inequality should have a contextual effect, because wealthy people have a lower marginal propensity to consume, and so they have a higher marginal propensity to save, and therefore invest. If they invest in bonds, that should lower interest rates, which should help stock prices. If the rich increase their investment in stocks, clearly the increased demand for stocks will raise stock prices, and CAPE.

The increased globalization of the economy has helped stock prices by increasing corporate profits, which is not a contextual effect. However, because the US tends to import far more than it exports, countries like China, Japan and Germany, are obliged to extend seller financing to the US. These countries receive US dollars in some form in exchange for their exports. If those dollars were not re-invested in some form in the US, then the US dollar would decline relative to the currencies of the exporters. So the yen, Euro, and yuan would rise, increasing the price of their exports, and lowering the volume of their exports. Therefore, the exporters are obliged to invest their US dollars in US assets such as direct foreign investment (buying US businesses), bonds, and stocks. Thus globalization (or trade) in conjunction with US trade deficits has increased global liquidity, and so it has raised the prices of assets, independent of the effect of corporate profits, inflation and interest rates on stock prices. Globalization has also increased industrial concentration, which I discuss below.

Quantitative Easing (QE)

QE is another contextual change, which has had an obvious effect on the valuation of stocks because it provided liquidity to the asset markets. By ‘quantitative easing’ I am referring to the large-scale purchase of assets, particularly bonds, by central banks. In conjunction with zero interest rates (ZIRP) or negative interest rates (NIRP), this policy has provided enormous liquidity to the financial system. It had not been tried before 2008. The Fed bought MBS, T-bonds and T-notes. The ECB bought sovereign bonds and corporate bonds. The JCB also bought equities.

Our Fed added a new wrinkle to monetary policy by paying interest on excess bank reserves to prevent negative interest rates. To raise short-term interest rates and engage in QT (quantitative tightening), those interest rates had to be raised. The Fed started QT in 2017. We will probably see QE again at a later date when the repercussions of QT become apparent.

What does the provision of liquidity and withdrawal of liquidity really mean? How does it work? I defer to John Hussman, who explained it beautifully in his November 2018 newsletter. Incidentally, Hussman hints that Bernanke did not truly comprehend what the implications of QE were. He wrote that “QE wasn’t about creating more liquidity or encouraging more bank loans or any of the other excuses tossed around.” “What QE did was replace interest-bearing T-bonds held by the public with a mountain of zero-interest money that was so uncomfortable to hold it drove investors crazy.”

In the case of QE, the Fed bought Treasuries (and MBS) from banks and put the money into the banks’ reserve accounts. This added to the money base, which is composed of vault currency and bank reserves. So QE “changed the mix of government liabilities. The public either owned Treasury bonds or base money.”

Once the monetary base had been created by QE, only the Fed controlled its size. They (the Fed) can increase it by buying more debt, or they can decrease it by either letting the debt mature, or selling it to the banks. The banks can’t decrease the monetary base. If they increase their lending, that does not reduce the reserves, because the reserves are not directly lent. Money is simply created for new loans and that adds to required reserves through the fractional reserve banking system. Therefore, the banks (and public) are stuck with a huge zero-interest rate monetary base. “They couldn’t get out of it in aggregate.” (The bold lettering is mine. The quotation marks denote Hussman’s words). They could only trade this zero-interest money to someone else for some other security regardless of price. Whoever sold them the security got zero-interest money in return. So the amount of zero-interest money did not change. There is no such thing as cash on the sidelines. However, the creation of new cash by the Fed will clearly raise asset prices.

The effect of trying to trade away the zero return cash raised the prices of every asset to a level where they “ would deliver long-term returns remarkably close to zero”. I presume that Hussman means risk-adjusted long-term returns, but it doesn’t really matter. Hussman is saying that by 2016 bonds and stocks were priced to deliver a multi-year total return of zero, equal to the rate on the zero-interest monetary base. That is, this is the process by which QE raised the PE10. Significant QT should therefore lower the valuation of stocks, but I will get to that.

So let me recap. QE was an extraordinary event, which may or may not recur, and it changed relationships, particularly the relationship described by PE; that is, how stocks are valued. The expected response of the economic system to QE and ZIRP was that it would engender a lot of borrowing for investment and consumption and result in high inflation. It was also expected that long-term interest rates would therefore rise, and bond prices would fall while stock prices would rise. The latter did occur for a couple of years, but then the inverse correlation between stock and bond prices broke down. Bond prices and stock prices in general rose together after 2011, and that is probably because of the effect of QE on all asset prices as described above.

The expectations of rapid economic growth and high inflation did not happen, because the monetary policy was a response to a private sector debt crisis. The private sector, especially the household sector, had too much debt already and a large quantity was in default. Those who may have wanted to borrow for consumption couldn’t do so. Those who were affluent didn’t need to borrow for consumption. We were in a liquidity trap. Because of the low growth rates in consumption, investment spending also did not respond much to the low interest rates.

There was one kind of borrowing that did respond to the provision of liquidity and low interest rates, however, and that was borrowing to buy assets as described above. The magnitude of borrowing by corporations, for the purpose of buying back their own stock, was not expected.

The Demographic Context and Savings for Retirement

The first baby-boomers started to enter the workforce in 1962. The first college graduates entered the workforce in 1968. The economy had difficulty for many years absorbing the flood of new workers. The peak income earning years occur at ages 45 to 55, and these are the years of peak spending and savings. The first baby boomers turned 45 in 1991. If the last baby boomers were born in 1965, they will turn 55 in 2020. So I’m saying that the demographic transition (look it up if you don’t know the stages of the demographic transition), and the baby boom created a spending and investment bubble from the 1980’s to 2020, which inflated stock valuations. Furthermore this investment boom was aided by several singular events that encouraged stock (and bond) purchases by the boomers.

I spent 10 years in college full-time, and started my first full-time job in 1975. ERISA (the Employee Retirement Income Security Act) had been passed in 1974. It created the 403(b) retirement plan for non-profit institutions. These plans permitted me to set aside money for retirement, and the income was not taxed at the time it was set aside. The earnings on that income were also not taxed. Income taxes are paid only when the retirement savings are distributed, and they must be distributed at a certain minimum rate when a person becomes 70.5 years old. I was given a choice between joining the state retirement system, which would manage my retirement savings for me and pay me a retirement income based on my salary over the last 5 years of employment, or managing my own retirement money in a 403(b) account. I chose the latter as did most of the people hired at the same time as me. We got to choose whether to invest in bonds, stocks or the money market.

It was called an optional retirement account, but there weren’t many options. We still had to pay Social Security taxes as well as contribute to the retirement plan, and so, between my employer and myself, 30% of my total income (my reported income plus employer contributions to social security and my retirement plan) was going to my future retirement. Also the fund firm that handled my 403(b) had few investment options initially, and the management firm also extracted a 5% front-end load on my contributions.

Had I joined the state retirement system, my money would also have been invested in stocks and bonds, but I suspect that those of us who managed our own retirement funds put a much higher percentage of our funds into the stock market than into bonds. We were young and could afford the risks of stock investments. Over time, as loads were removed and the mutual fund companies permitted me to actually trade daily, I ended up owning only stocks or cash; no bonds.

The 403(b) plans were the forerunner of the 401(k), traditional IRAs, and Roth IRAs. The legislation that created the 401(k) was passed in 1978. Individual retirement accounts were created by ERISA in 1974, but they were restricted to individuals who didn’t have employer-sponsored retirement plans. In 1981 the Economic Recovery Act allowed all workers to create an IRA, whether they had an employer-sponsored plan or not. The Taxpayer Relief Act of 1997 created the Roth IRA.

The tax-deferred retirement plans clearly provided liquidity for investments in assets. People were able to save far more money than before because the size of their contributions toward retirement, which were not taxed, was greatly increased. Also the earnings on these retirement funds, including corporate dividends and interest on bonds, were not taxed, and so they were not withdrawn from investment vehicles until people retired, when they had to withdraw savings starting at age 70.5.

These retirement vehicles sponsored a flood of money into savings by the baby boomers, which were primarily invested in stocks rather than bonds, especially when brokerage services became readily available for investing the retirement funds, and investment fees plummeted. I do not know when this happened, but I became aware in the early 2000’s of the availability of brokerage services for 403(b) and 401(k) plans.

I think that the increased availability of brokerage services in retirement plans, encouraged increased flows of funds into stock assets, as did the creation of discount brokers, on-line discount brokers, index funds, ETFs, and ETNs. The SEC de-regulated brokerage commissions in 1975. On line trading was widely available by the mid-1990s. I recall that I could do on line mutual fund switches in my 403(b) retirement account by 1997, and I could switch funds daily, which I often did. Daily trading encouraged me to take more risks in the stock market; that is to focus on equities. I never earned more than $50,000 a year, but by 12/31/1999 my retirement plan surpassed $1,000,000. I suspect quite a few other retirement plans did also.

John Bogle’s Vanguard Funds first provided equity index funds, which greatly lowered mutual fund management fees, in 1976. Lower fees meant more money that could go into stocks.

The first ETF arrived in 1993 (SPY), and these also provided low management fees, which increased liquidity. The diversification provided by ETFs and the fact that they could be traded at any time of the trading day, also provided reassurance to investors that there was less risk in buying stock indexes. I certainly was reassured by the fact that I could place stop-losses or triggers in my retirement funds to control my losses. I was scarred by the 1987 market crash when we could not withdraw our money until the end of the trading day at which time stocks were at their low point on that October 19 th.

All these innovations made it much easier and cheaper for individuals to invest in common stocks (and bonds). An increase in liquidity, by itself, will elevate the prices and valuations of common stock and bonds. If there is more money wishing to purchase these assets without a compensatory increase in the desire to hold cash (or bonds), then prices will be bid higher.

Do other countries have our individual deferred tax retirement plans, which can also invest in common stock? Not that I could find. If not, that fact would account for the perennial higher valuations for common stocks in the US compared with other developed economies, except for Japan. Of course, the US also has a higher rate of growth in its workforce than do Japan and the EEC.

Corporate stock buy-backs

Until 1982, US corporations were unable to buy back their own stock except in exceptional circumstances. Rule 10b-18, made buy backs conducted in the open market legal in that year. Most of the buybacks (95%) are done in the open market. This is also legal in developed markets overseas. Buybacks in the US jumped from 1984 to 1987, 1991 to 1999, and they have soared since 2003, with only a pause from 2007 to 2009 during the Great Recession.

In 1982, buybacks amounted to approximately $5 billion. They reached $349 billion (nominal dollars) in 2005 and exceeded $600 billion in 2018. For many years the buybacks did not prevent the dilution of stocks, which resulted from remunerations to management in the form of stock options and restricted stock. Stock options were very popular in the 1990’s, and so the creation of new shares exceeded the shares bought back by corporations. But that changed by 2004. Except for the period from 2008 to 2011, the total number of shares outstanding has declined since 2004. Hussman (December 2018 newsletter) wrote that the total number of outstanding shares declined by a total of 9.4% since 2004, an average rate of 0.7% a year. The decline in the number of shares means that earnings per share should have increased by 10.4%, if there were actually no change in total corporate earnings. Hussman stressed that this increase in earnings is not particularly significant. It neither justifies the high CAPE levels nor the other indicators of over-priced earnings that have prevailed since 2013. But, I think that corporate demand for their own shares has contributed greatly to the higher average PEs of stocks, since 2004 in particular. If we assume a net purchase of $200 billion in stocks (net of the creation of new stock), then that $200 billion will clearly raise, and has raised the price of stocks, as long as the net withdrawal of funds from the stock market by individuals and institutions was less than $200 billion.

Notice that as the baby boomers started to liquidate stocks, corporate buy backs and QE continued to elevate valuations.

Industrial concentration

Not only has the number of outstanding shares declined, but also the number of publicly listed US corporations has declined from 7562 in 1998 to 3812 in 2015. One reason is that more corporations have gone bankrupt than were created. Also, corporations merged, and investor groups such as private equity funds took them private.

The decrease in the number of public corporations is a reflection of economies of scale, which, in turn, is a result of continued technological advances in production and of globalization. Economies of scale contribute to monopolization. Small start-up companies cannot compete with large established firms in producing existent products, because their costs of production are higher when they are at small scale. China has undercut the US production of goods, not only because of lower labor costs, but also because of economies of scale in producing goods for the whole world. Globalization has greatly encouraged the realization of economies of scale and fewer firms providing goods and services.

Legislation also had an influence on industrial concentration. The McFadden Act forbade the creation of interstate banks in the US. However, states could allow an out-of-state bank holding company to own and operate banks within their states. Many states permitted the creation of regional banks in the 1980’s. So there was some degree of interstate banking by the 1990’s, but the creation of interstate bank branches on a grand scale did not occur until the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 got rid of the McFadden Act. No bank holding company may control more than 10% of national assets on deposit, but giant national banks were now possible, and they quickly formed. Big national banks rapidly acquired smaller regional and local banks.

Financial industrial concentration was further aided by the repeal of the Glass-Steagall Act in 1998, which allowed commercial banks to merge with insurance companies and investment banks. The big commercial banks promptly acquired investment-banking functions, and grew in size. Fewer companies and fewer outstanding shares mean a higher valuation for all stocks.

Fewer companies as a result of economies of scale means that companies have greater pricing power over their products, and this has helped elevate profit margins since 2009 to levels well above their historical average. But high profit margins means higher profits. It is not a change in context. The prices of stocks are higher because the earnings are growing as a result of higher profit margins. The relationship between earnings and stock prices is not changed by the persistence of higher profit margins. It is changed, however, by the fact of fewer companies and fewer company stocks that can be bought.

The Effect of Private Capital

The National Securities Markets Improvement Act of 1996 (NSMIA) basically gave all regulatory power over the creation and selling of securities to the SEC. State powers were greatly diminished. The Act removed a limitation on the number of qualified purchasers or participants in a hedge fund, with the result that there was an increase in the number of university endowments, pension funds, and other financial institutions which invested in hedge funds. The Act was one factor in greatly increasing the amount of private capital that was being invested outside of stock markets. The number of IPOs per year peaked in 1996.

Private capital refers to venture capital funds, private equity funds, and portions of hedge funds, mutual funds and pension funds that do not purchase assets on public exchanges. Evans and Farre-Mense (Harvard Law School Forum on Corporate Governance and Financial Regulation, Sep. 28, 2017, on-line report) raised the question, why does private capital like to stay private? One reason given is that technological changes have decreased the capital requirements of start-up businesses. Therefore, the business founders are often able to maintain majority control of their business, and avoid being forced into an IPO. The authors do not mention the Sarbanes-Oxley Act of 2002, which generally does not apply to private businesses, but that Act must have also inhibited private companies from going public. Whatever the reason, Evans and Farre-Mense observed that there was a significant increase in the percentage of late stage start-ups that remained privately held by venture capitalists, and so that accounted in part for the decrease in IPOs. Privately held firms have an interest in staying private if they make money. Lyft and Uber do not earn profits, and so they are going public.

If private capital as a percentage of total capital for investment increases, the PE of publicly held stocks must increase. I will illustrate why this is so using a model. Assume an economy with $50 billion of public and private business profits, and assume $1 trillion of investment capital seeking investment in that $50 billion of earnings. The average PE will therefore be 20 (total market capitalization/E = $1 trillion/$50 billion = 20). Assume there is private capital, which wants investment in $25 billion of those earnings, but it is only willing to pay a PE of 15. Therefore, $375 billion of capital is invested at a PE of 15 (market capitalization = 25 billion times 15). This leaves $625 billion of capital chasing $25 billion of earnings in public markets, and so the public market PE is 25. If private investment capital increases as a percentage of total capital, but it seeks reasonable earnings, then the public stock markets receive the speculative capital that is prepared to bid for stock at higher PEs, or stocks that have no earnings.

Other Events

There are probably other events, which didn’t occur to me, that have affected the overall valuation of stocks. The known and unknown influences are singular events, like the legislative acts, or on-going processes like the demographic transition. Again, the events cannot be described as variables, and a single event does not act independently of the other events. It is a nexus of events, which changes many of the inter-relationships between variables in an economic system.

Some, or many of the events, may not have additive effects. They have interactive effects. Positive synergy is when the combined influence of two variables on either another variable, or on a relationship between two variables, is greater than the sum of their effects. Negative synergy is when the combined effect is less than the sum of the effects. For example, what would the effect of the newly invented tax-deferred retirement plans have been on stock valuations, if the baby boom bulge entering their peak earning years had not coincided with the invention of these plans? What would the effect have been of the baby boomers entering their peak earnings without the invention of these retirement vehicles? Actually, we don’t know the answers to each of these questions, and we don’t know whether the synergy was positive or negative. But, given the extraordinary increase in average PE10 since 1990, my hunch is that the baby boomers, the retirement plans, and corporate buybacks combined had a positive synergistic effect on stock valuations.

I hope you liked this perspective on stock valuations. In Part III I will explore what we have to look forward to in terms of future valuations. I think they will remain high, but that provides no assurance that stock prices can’t collapse.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: If readers use my ideas in anything they write, they should cite me as the Social Scientist. If they publish a book or article for remuneration other than on SA, and use my ideas, then I wish to be cited using my real name. My name can be obtained from Seeking Alpha, or from me via private message.