Equity market valuations just tied to bond rates?

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BlueEars
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Equity market valuations just tied to bond rates?

Post by BlueEars » Tue Aug 16, 2016 10:35 am

I read this article by Hulbert with some concern: http://www.marketwatch.com/story/heres- ... 2016-08-16

Ignoring the hype title, I haven't seen a comparison of this nature before:
...an equally sobering picture is painted when we compare the current market not to historical averages but to just those past occasions when equities were at the top of a bull market.
And this reminder of market timing dangers:
To be sure, valuation indicators are not helpful guides to the market’s shorter-term direction. Overvalued markets can stay overvalued for some time, and even become more overvalued. But value eventually wins out.

For example, it was in December 1996 that Yale’s Professor Shiller gave his now-famous lecture to the Federal Reserve about irrational exuberance. His analysis struck many as silly during the subsequent three years in which stocks continued to soar; when the dot-com bubble hit he looked like a genius — and he eventually was awarded the Nobel prize.
I had not seen a comparison to past peak markets before. So I looked at the PE1 data from Shiller. That seemed to agree with Hulbert's data for about 10 past peak bull markets. See my table below which shows some past bull peaks and PE1 data. My guess is about PE1=24 (from my way of using the Shiller data). Then I added the 5 year Treasury yield to the table. Well, as we know the yields are extremely low right now.

Image

So my question is, are the current high market valuations just a reflection of high valuations for stock's competitive alternative -- bonds?

And a perhaps more difficult (unanswerable?) question: shouldn't we expect the valuations to stay relatively high if rates just go up very gradually? Very gradually being maybe 1 or 2 quarter point increases per year.

Tigermoose
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Re: Equity market valuations just tied to bond rates?

Post by Tigermoose » Tue Aug 16, 2016 10:45 am

My theory:

There is an overabundance of available capital for investment at the present time. This is due to income inequality and the central banks backstopping financial assets from having a serious decline. Since the 1% hold about 50% of all the global wealth, and they tend to invest their excess capital in bonds and equities, that means we have high valuations in both bonds and equities. This is also why CPI inflation stays low. Now, if that capital being held by the 1% gets "redistributed" or starts going to real wages somehow, then we will see GDP increase and inflation start up again. I think we could see very high PE ratios, and continued low bond yields, before this paradigm changes.
Institutions matter

Joey_Freshwater
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Re: Equity market valuations just tied to bond rates?

Post by Joey_Freshwater » Tue Aug 16, 2016 11:25 am

Tigermoose wrote:My theory:

There is an overabundance of available capital for investment at the present time. This is due to income inequality and the central banks backstopping financial assets from having a serious decline. Since the 1% hold about 50% of all the global wealth, and they tend to invest their excess capital in bonds and equities, that means we have high valuations in both bonds and equities. This is also why CPI inflation stays low. Now, if that capital being held by the 1% gets "redistributed" or starts going to real wages somehow, then we will see GDP increase and inflation start up again. I think we could see very high PE ratios, and continued low bond yields, before this paradigm changes.
When someone buys a bond or an equity, it's not like the money disappears. Money probably ends up on a bank balance sheet. Banks are being forced to hold large amounts of capital which is probably why CPI stays low.

Tigermoose
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Re: Equity market valuations just tied to bond rates?

Post by Tigermoose » Tue Aug 16, 2016 11:30 am

Joey_Freshwater wrote: When someone buys a bond or an equity, it's not like the money disappears. Money probably ends up on a bank balance sheet. Banks are being forced to hold large amounts of capital which is probably why CPI stays low.
The money velocity is very low right now, and I think this is because the 1% has 50% of the capital, and thus the money is not trading hands as fast as it would if the capital was in the hands of people spending it on goods and services. The M2 money supply is high, but it has super low velocity - thus low CPI.

https://fred.stlouisfed.org/series/M2
https://fred.stlouisfed.org/series/M2V
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BlueEars
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Re: Equity market valuations just tied to bond rates?

Post by BlueEars » Tue Aug 16, 2016 12:08 pm

Interesting theoretical thoughts but my questions were more pragmatic investor oriented ones.

Repeating from OP:
So my question is, are the current high market valuations just a reflection of high valuations for stock's competitive alternative -- bonds?

And a perhaps more difficult (unanswerable?) question: shouldn't we expect the valuations to stay relatively high if rates just go up very gradually? Very gradually being maybe 1 or 2 quarter point increases per year.

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siamond
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Re: Equity market valuations just tied to bond rates?

Post by siamond » Tue Aug 16, 2016 12:15 pm

BlueEars wrote:So my question is, are the current high market valuations just a reflection of high valuations for stock's competitive alternative -- bonds?

And a perhaps more difficult (unanswerable?) question: shouldn't we expect the valuations to stay relatively high if rates just go up very gradually? Very gradually being maybe 1 or 2 quarter point increases per year.
Well, I would venture to guess that that very low interest rates (and bond yields) do motivate some investors to buy more stocks, hence adding to the high valuation of stocks

But remember, stock returns and bond returns are NOT negatively correlated (when one zigs, the other zags: nope, not the case). The correlation is basically zero. Which means that they move(d) totally on their own. And this observation should answer your questions.

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whodidntante
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Re: Equity market valuations just tied to bond rates?

Post by whodidntante » Tue Aug 16, 2016 12:46 pm

One model of stock valuation is discounted cash flow. I believe Buffett uses the 10 year treasury. That model leads you to conclude that valuations should be high right now.

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Re: Equity market valuations just tied to bond rates?

Post by Boglegrappler » Tue Aug 16, 2016 1:24 pm

So my question is, are the current high market valuations just a reflection of high valuations for stock's competitive alternative -- bonds?

And a perhaps more difficult (unanswerable?) question: shouldn't we expect the valuations to stay relatively high if rates just go up very gradually? Very gradually being maybe 1 or 2 quarter point increases per year.
1. Yes, largely. PEs reflect the anticipated growth (currently tepid at best) and the available rates of return on alternatives. Since there isn't much growth factored into the current p/e ratio, its obviously influenced by the lower rates of return available anywhere else.

2. Yes. IMO, the reason the market is currently inching up even higher is that people are coming to the realization that rates aren't going up. (The market never fully factored in the low rates because it felt they were a temporary aberration orchestrated by the Fed. That perception is changing.)

Even if the fed moves, its not going to make much difference. They aren't in charge of the economy. No one is. The reason rates are low is that there is precious little return on incremental capital investment in many industries. There are some sectors where there is virtually no sales growth, so there isn't a reason to seek out a bank loan to build new facilities and productive capacity.

This is also why you are seeing serious discussions about "helicopter" money. They are out of tools.

Tigermoose
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Re: Equity market valuations just tied to bond rates?

Post by Tigermoose » Tue Aug 16, 2016 3:52 pm

BlueEars wrote:Interesting theoretical thoughts but my questions were more pragmatic investor oriented ones.

Repeating from OP:
So my question is, are the current high market valuations just a reflection of high valuations for stock's competitive alternative -- bonds?

And a perhaps more difficult (unanswerable?) question: shouldn't we expect the valuations to stay relatively high if rates just go up very gradually? Very gradually being maybe 1 or 2 quarter point increases per year.
To more directly answer your question: current high market valuations are NOT JUST a reflection of high valuations for stock's competitive alternative -- bonds. My previous answer explains why there are other factors at play --- the amount of capital being invested. That is the root cause of why bonds and stocks are BOTH high right now.
Institutions matter

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JoMoney
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Re: Equity market valuations just tied to bond rates?

Post by JoMoney » Tue Aug 16, 2016 4:04 pm

Stocks are indeed (relative to the past) high priced based on fundamental multiples.
Bonds are at unprecedented high prices (based on historical yields).
Growth has been sub-par. My hope, is that fundamental growth returns towards more historical norms.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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BlueEars
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Re: Equity market valuations just tied to bond rates?

Post by BlueEars » Wed Aug 17, 2016 8:47 am

Thanks for the replies so far. It is an interesting issue to help answer why we are where we are and where equity markets might be going.

This comment by the SF Fed President shows some of his reasons why interest rates are low (link: http://www.bloomberg.com/news/articles/ ... es-rethink)
Shifting demographics, slower productivity and economic growth and the fact that emerging markets are seeking large reserves of safe assets have all lowered the natural interest rate, from 4 percent to 4.5 percent in the short term to a new normal of 3 percent to 3.5 percent, or even lower. Those figures count in inflation.
And this from Ben Bernicke (link at https://www.brookings.edu/2016/08/08/th ... ry-policy/):
Importantly, standard macroeconomic analysis implies that the three variables above are largely out of the control of the Fed: Potential output growth depends on factors like productivity and population growth, the natural rate of unemployment is determined by various features of the labor market (such as the extent of mismatch between workers and jobs), and, given the inflation rate (which is set by the Fed), the terminal policy rate depends on factors like the rate of return on capital investment and the supply of saving. Changes in policymakers’ estimates of these variables thus reflect reassessments of the economic environment in which policy must operate.

So how has the Fed’s thinking changed? The table below shows long-run projections of output (y*), the unemployment rate (u*), and the federal funds rate (r*) made by FOMC participants in June 2016 (the most recent available) and in each June of the prior four years. Table follows in the article.
All the underlying economic issues are somewhat confusing, interesting but confusing and unclear, to me. But interest rates are low and not likely to move up quickly it seems. Hence, just maybe stock PE's are where they are for a reason and will continue to stay highish? Or maybe I just want this good market to continue and being too optimistic? :happy

magneto
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Re: Equity market valuations just tied to bond rates?

Post by magneto » Wed Aug 17, 2016 9:51 am

JoMoney wrote:Stocks are indeed (relative to the past) high priced based on fundamental multiples.
Bonds are at unprecedented high prices (based on historical yields).
Growth has been sub-par. My hope, is that fundamental growth returns towards more historical norms.
Gov't Bonds in quite a few countries are now offering -ve real yields and even -ve nominal yields.
This investor does not find such offerings enticing, but rather a seemingly foolish (wasting purchasing power) investment!

But could this be a misinterpretation of investor behaviour?
Are such investors in fact smarter/better informed?

Is the whole world after a brief respite heading for deflation?
Is the full deployment of Keynesian (and Fisher) tools, ultimately going to fail?
Prior to the 1930s periods of deflation were the norm, being part of naturally re-occuring cycles.

Current -ve Bond yields might then start to make some sort of sense.

Stocks agree while expensive, are not nearly so troubling as Bonds.
2000 was far more extreme.for Stocks.
Nevertheless we have found ourselves needing to part top-slice Stocks over the last few months, all as per Investment Plan.
Domestic UK Gov't Bonds (Gilts) now all sold for reasons as above, but still retain a position in Short-Term IG Corps while they eke out a +ve real yield.
'There is a tide in the affairs of men ...', Brutus (Market Timer)

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patrick013
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Re: Equity market valuations just tied to bond rates?

Post by patrick013 » Wed Aug 17, 2016 11:35 am

It could be complete conjecture but you could say that
there's bulls that see the 500 = 2300 with tentative
and optimistic EPS projections pricing up the 500.

And you could say that there's bears that see the 500 =
2000 based on pessimistic EPS projections. They are
pricing up bonds, shifting their money from stocks to bonds
with a little help from foreign purchasers mostly interested
in US bond investments.

It's rare that stocks and bonds are overbought at the same
time, setting high price/low yield records etc..

So it's a better time to hold or stay the course, or perhaps
rebalance a bit. DCA would result in less shares bought if
stock prices stay high or more shares bought if stock prices decline
a bit.
age in bonds, buy-and-hold, 10 year business cycle

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