LONDON (Reuters Breakingviews) - Stocks might not be expensive by some standards. It is, after all, impossible to calculate the objective present value of a financial asset with an unknown future cash flow in an unpredictable world. However, equities are unquestionably expensive in the only way that can be counted: relative to the past.
There are two plausible measures for long-term comparisons. The first is the Cyclically Adjusted Price-to-Earnings ratio. Popularised by Nobel Prize-winning economist Robert Shiller, the CAPE compares the current price of a stock to its average annual inflation-adjusted earnings over the last decade. The second measure is Tobin’s Q, developed by another American laureate, James Tobin. It attempts to measure the relationship between a company’s stock market capitalisation and the cost of replacing its assets.
Both CAPE and Tobin’s Q can be calculated for the whole market, although a lot of work is required to keep the numbers comparable. Investors can thank the British economist Andrew Smithers and his successors, who have developed more than a century of reasonably consistent measures for the U.S. S&P 500 index (and its predecessors). Their latest estimates suggest massive overvaluation – the CAPE, which covers the whole market, is 108 percent above the historical average, and the Q ratio, which is not valid for financial companies, is 77 percent higher.
Some caution is needed, since Smithers simply defines fair value as the post-1900 average. A lot has changed in the economy and the stock market in the past 119 years. Still, today’s ratios are 20 to 40 percent above the peak of the bull market of the 1960s. The only time they were higher was right before the bubble of the late 1990s ended. That burst of exuberance was followed by an inflation-adjusted 48 percent decline in the S&P 500, according to Macrotrends, a compiler of investment data.
That experience encouraged prognosticators to use CAPE and Q as indicators of stock market peaks. So far, the indicators just keep on rising. The elevated measures are, though, signs of the times: in the economy, in investor psychology, and in monetary policy.
Start with the economy. It is a profitable age. Between 2000 and 2018, reported after-tax profit for the members of the S&P 500 have increased by 164 percent, outpacing the increase in nominal U.S Gross Domestic Product, which doubled over the same period. From 2007, just before the profitability collapse connected to the 2008 financial crisis, GDP is up 42 percent, while the earnings of S&P 500 companies have increased 80 percent.
In effect, owners of common stock are pocketing a higher portion of economic output. Unsurprisingly, this rebalancing has buoyed the psychology of shareholders. They see no reason for the favourable trend to end. That rise in the CAPE ratio shows turbocharged optimism. In effect, shareholders are paying more for earnings which have already been rising faster than the economy for decades.
In a different political environment, it would be reasonable to expect the profit pendulum to swing in the other direction soon. That does not seem to be happening now, despite calls by left-wing politicians and economists for higher corporate taxes and stricter enforcement of competition rules. A turn is particularly unlikely in the United States, where a booming stock market is often considered a mood-enhancer, especially for the politically potent affluent class.
The tide of investor enthusiasm about future earnings is also lifting some pretty leaky ships. Ride-hailing operators Uber and Lyft, for example, are not only massively in the red but have no plausible route towards black ink. The two companies made a combined operating loss of $4 billion in 2018, a stunning 30 percent of their joint reported revenues of $13.4 billion. This apparent business failure has hardly discouraged investors. After Uber’s imminent initial public offering, the combined market capitalisation of the two companies is expected to be around $100 billion.
One reason for such incautious optimism is the ready availability of not very expensive money. For more than a decade, policy interest rates have consistently been well below the rate of inflation in most developed economies. For much of that time the easing policies of central banks have pushed large amounts of newly created funds into financial markets. Cheap money has almost become part of the established order of the financial universe.
The effect of this money-flood on consumer price inflation has been small to non-existent. The same is true for the economy. However, low returns have pushed investors into riskier assets, while some of the cheap money has presumably been lent to equity buyers, boosting demand, share prices and positive thinking. Cheap corporate borrowing also boosts earnings growth at leveraged companies, reinforcing the conviction that good news will continue.
If central bankers and their political masters thought asset price inflation was dangerous, they might well respond to the high values of Tobin’s Q and CAPE by trying to take money out of financial markets. However, such thinking is contrary to the current political and economic orthodoxy.
Most likely, share prices will only fall when investors finally get frightened about corporate profitability and growth. To judge from the reception given to Uber, such fear is still pretty far away.
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