Note: This is an extended commentary, detailing what I believe are critical considerations for investors here. You’re probably going to need a cup of coffee, a snack, a calculator, and possibly a nap along the way. There's a lot here, and reading it more than once may be useful. To feature this discussion for a sufficient time, and to prevent it from being immediately obscured by new content, my next market comment will be posted on Monday, November 6, 2017 - JPH

“Valuations make sense with interest rates where they are.”

- Warren Buffett, October 3, 2017

It’s such a comforting, even satisfying assumption; the idea that “lower interest rates justify higher valuations.” The idea is one of the most basic principles of finance. Indeed, investors could consider it a law of investing. Except for the fact that it’s an incomplete sentence. Unfortunately, the convenience of investing-by-slogan, rather than carefully thinking about finance and examining evidence, is currently leading investors into what is likely to be one of the worst disasters in the history of the U.S. stock market.

Here are the propositions that are actually true:

  • An investment security is nothing but a claim on some stream of expected future cash flows that will be delivered into the hands of investors over time.
  • Provided that the stream of expected future cash flows is held constant, discounting those future cash flows at a lower rate (which is the same as accepting a lower future rate of return), will result in a higher “justified” price today, and this impact can be quantified.

Below, we’ll also establish and demonstrate some additional propositions:

  • If interest rates are low because growth rates are also low, no valuation premium on stocks is “justified” by the low interest rates. Prospective returns are reduced without the need for any valuation premium at all.
  • Provided that a valuation ratio is based on a “sufficient statistic” for long-term cash flows, the logarithm of that valuation ratio will, in turn, act as a sufficient statistic for long-term investment returns.
  • Revenues and margin-adjusted earnings have historically been far more reliable “sufficient statistics” of future cash flows than year-to-year earnings, or even 10-year averages of earnings.
  • Currently depressed interest rates are indeed associated with unusually weak current and prospective U.S. growth rates, implying that elevated stock market valuations are not, in fact, “justified” by interest rates at all.
  • Margin-adjusted valuation ratios behave as sufficient statistics for likely future stock market returns, and adding information about interest rates improves neither the reliability of return projections, nor the current level of those projections.

By the end of this comment, all of these will be clear. The upshot of these propositions is this. At present, the most reliable measures of U.S. equity market valuation - the measures that are best-correlated with actual subsequent market returns in market cycles across history - are 2.75 times (175% above) their historical norms. Given that depressed interest rates are matched by commensurately low U.S. growth rates, little or none of this premium is actually “justified” by interest rates. Rather, the S&P 500 is likely to post negative total returns over the coming 10-12 year horizon, with a likely interim loss in excess of -60%.

Moreover, even if the growth rates of nominal GDP, S&P 500 revenues, and other fundamentals were to literally double to historically normal rates, yet Treasury bond yields could be held 2.5% below their historical median for another decade, the combination would only “justify” a valuation premium for the S&P 500 of about 2.5% x 10 years = 25% above its corresponding historical valuation norms. We’re already 175% above those norms. There's no way to make the arithmetic work without assuming an implausible and sustained surge to historically normal economic growth rates, a near-permanent suppression of interest rates despite a full resumption of normal economic growth, and the permanent maintenance of near-record profit margins via permanently depressed real wage growth, despite an unemployment rate that now stands at just 4.2%.

There’s little doubt that the general level of long-term interest rates should be markedly lower than historical norms. But that’s because prospects for long-term growth are also markedly lower than historical norms. Again, the problem is that this combination deserves no valuation premium at all. Expected future stock market returns would be commensurately lower even in the absence of a valuation premium. That’s just how the arithmetic works.

Today’s obscene market valuations are largely the result of a) ignoring the growth side of this relationship, and b) activist central bank policies that have repeatedly driven short-terminterest rates to levels that create a mentality of yield-scarcity among investors; where they stop quantifying the effect of rates and simply decide that “there is no alternative” to blindly speculating in risky assets regardless of their valuations. That’s what created the mortgage bubble that ended in the global financial crisis, and it’s what has created the “everything” bubble today. With deep respect, my impression is that Warren Buffett’s statement reflects that same lack of quantification.

What follows is an exposition that includes both theory and evidence. I’ve drawn freely on some of my prior commentaries, so parts will look familiar to long-time readers. But this is important, particularly at present extremes, so I hope you’ll spend some time with it.