The U.S. Federal Reserve voted earlier this week to keep interest rates near the zero mark, demonstrating an ongoing commitment to the policy goals spelled out last year during an important meeting of the Federal Open Market Committee (FOMC).
In a statement summarizing its latest interest rate decision, the Federal Reserve reiterates that its goals are to promote maximum employment and to leverage its full suite of policy tools to help the U.S. economy bounce back from the severest effects of the coronavirus pandemic.
“The COVID-19 pandemic is causing tremendous human and economic hardship across the United States and around the world,” the Fed says. “The pace of the recovery in economic activity and employment has moderated in recent months, with weakness concentrated in the sectors most adversely affected by the pandemic.”
The Fed makes the obvious point that the path of the economy will depend significantly on the course of the virus, including progress on vaccinations, noting that the massive public health crisis continues to weigh on economic activity, employment and inflation. Overall, the Federal Reserve’s statement represents yet another indicator that it will be a long time before interest rates climb back to the levels seen in previous decades—and, in fact, some believe that may never happen again.
‘Are Stock Prices Insanely High?’
Comments shared with PLANADVISER by Brad McMillan, chief investment officer (CIO) at Commonwealth Financial Network, suggest this interest rate outlook spells good news for those who are concerned about the historically high valuations (and generous returns) being enjoyed by stock market participants today. This concern is only natural, he notes, given the serious headwinds facing so many sectors of the U.S. and global economies.
“There has been a lot of talk about whether the stock market is in a bubble,” McMillan says. “As usual, there are distinguished professionals on both sides of the debate, armed with convincing statistics and arguments. So what is the average investor to do? We do what we usually do: try to understand the facts of the situation. Let’s start with the root question. Are stock prices at an insanely high level?”
In McMillan’s view, almost every price-based indicator says this is the case.
“Whether you look at sales, book value, earnings or any price-based metric at all, stocks are not only incredibly expensive, but close to as expensive as they have ever been,” he explains. “For many analysts, this fact closes the case. There is, however, another way to look at stock valuations, and that is to compare returns instead of prices.”
McMillan says this approach acknowledges the fact that stocks do not stand alone in the financial universe but, rather, compete with other assets.
“Specifically, they compete with bonds,” he says. “The more bonds are paying in interest, the more attractive they are compared with stocks. For an investor, there is, therefore, a direct relation between interest rates and stock prices. Think about it. Over time, the stock market has returned around 10% per year. If you could buy a risk-free U.S. Treasury bill giving you the same 10%, wouldn’t you buy that instead?”
McMillan says the argument boils down to the fact that rational actors do not take risk if they don’t have to.
“If you are getting 2% from your bonds, then you are giving up much less when you trade them for stocks, and you can and will pay higher prices for stocks,” he says. “Looked at another way, with rates lower, the present value of future earnings of a stock is higher. Either way, when rates go down, you would expect stocks to go up. And this relationship is what we have seen.”
McMillan says the ultimate question becomes whether current stock market prices are about lower rates or investor exuberance.
“Robert Shiller, the Nobel prize-winning economist who wrote ‘Irrational Exuberance,’ did just this calculation,” McMillan observes. “Shiller points out that with interest rates where they are right now, on a relative valuation basis, stocks are not that expensive at all. In other words, current prices could well be a rational response to low rates, instead of irrational exuberance. Not a bubble, but simply a result of changed policy.”
A Consensus Position?
McMillan’s view seems to be something of a consensus position, as it’s shared by other market watchers, including, for example, Nigel Green, chief executive and founder of deVere Group.
“As stocks hit historic highs, there are fears that the boom we’re currently experiencing could end in a bust, similar to the dot-com era,” Green observes. “For the time being, we believe that concerns over a large stock market bubble are overblown. To understand the reasoning, we need to look at why markets are valued so high at the moment. Essentially, it comes down to the unprecedented levels of monetary and fiscal support, the ultra-low bond yields, the historically low interest rates, that earnings are up, and that both institutional and retail investors have large reserves of excess cash.”
Green calls this “a rare combination” and, on the back of all this, he expects that it will take years for markets to cool significantly.
“What is perhaps more concerning are micro-bubbles of a small group of stocks that consistently rush to new highs and reject all balanced valuations,” Green notes, citing the ongoing situation playing out with the likes of GameStop and AMC. “Hyper growth stocks, which often lure in do-it-yourself investors with their headline-grabbing current performance, at the moment appear to have no ceiling. However, highly profitable incumbents in their sectors could soon bring the ‘story stocks’ back down to earth, with their valuations headed for a meaningful correction.”
Another major risk of micro-bubble stocks, Green says, is that they overshadow the potential of new stocks and sectors, with investors subsequently missing key low entry point opportunities.
Several other points of caution are raised by Meb Faber, co-founder and CIO of Cambria Investment Management, in a recent (and colorful) blog post on this general topic. The piece raises a series of important questions about the complex set of variables and assumptions at play here, reminding everyone that oft-repeated market maximums, such as those declaring that low rates can justify sky-high stock valuations, often obscure a much more sophisticated set of interdependent factors that are truly at play.