The Cure for High Stock Valuation

Two weeks ago, the ASX 200 rallied hard.

From 9-14 June, the market rallied 3% to 5,827 points. It was the best continuous run we’ve had since 9 November, 2016. And it’s all thanks to a few key players — the big four banks and biotech CSL Ltd [ASX:CSL]. CSL hit a new all-time high of $142.04 per share.

But since then we’ve fallen back down. The ASX 200 sits around 5,700 points for the year. It brings us barely into positive territory for 2017.

And while we are flat, global indices are racing ahead. China’s Hang Seng Index is up an amazing 16.7% year-to-date. And US investors have bid up the S&P 500 to new all-time highs. The index is now up almost 9% in 2017.

But while prices have climbed, earnings are yet to follow.

As reported by The Australian Financial Review:

A record 44 per cent of global fund managers believe share markets, particularly those in the United States, to be overvalued after years of overstimulative monetary policy, according to a monthly Bank of America Merrill Lynch survey.

In the note, titled “Fed up with Bubbles”, three quarters of professional money managers polled said they believe the internet stocks that have driven Wall Street to record highs are either “expensive” or “bubble-like”.

But equities, especially in the US, could get even more expensive in the near future.

Sticking to their word

As expected, the US Federal Reserve raised interest rates to 1.25% on 15 June. It was the second rate rise in 2017. And, despite persistently low inflation in the US, we could see yet another rate rise in the next few months.

Take a look at what the Fed said in its monetary policy statement (my emphasis):

‘…the labour market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have moderated but have been solid, on average, since the beginning of the year, and the unemployment rate has declined.

Household spending has picked up in recent months, and business fixed investment has continued to expand.

On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent.

Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

It’s almost as if the Fed raised rates based on an assumption — jobs have improved so inflation will too. Yet as the Fed said, based on market measures, US inflation is still weak. So why did it increase interest rates?

Because it said it would.

The Fed has been adamant about raising rates for a while. In 2016, it didn’t have the opportunity to increase rates as much as it would’ve liked. So now it’s doing it in 2017.

For those fund managers who think US equities are expensive, the situation just got worse.

Interest rates play a factor in valuing almost every asset. As interest rates increase, the rate at which investors discount future cash flows also increases. Thus, future earnings need to be higher to justify today’s prices.

Bank of America (BoA) Merrill Lynch Chief Investment Strategist Michael Hartnett explains:

Market vulnerability to profit weakness is very high, with investors’ perception of excess valuation coinciding with high global profit expectations.

In a poll of 180 fund managers, BoA Merrill Lynch found that more fundies are increasing cash balances. Average cash balances are up from 4.9% in May to 5%, far higher than the 10-year average of 4.5%.

What’s the solution?

If low interest rates are to blame for sky-high stock prices, then high rates are the fix, right?

Not exactly. In theory, when interest rates rise, it hurts stocks. This is because stocks become more expensive on a valuation basis, and bonds and bank deposits become more attractive.

But in practice, this doesn’t always happen.

As Michael Foster explained in Forbes:

In the early 1980s, interest rates doubled from their 1978 levels over a few years—and the stock market rose 50% at the same time.

This wouldn’t mean much if real interest rates were flat or even declined over the same period. Unlike nominal rates, the real interest rate takes inflation into account.

For example, if inflation is 2% annually and you earn 3% on a term deposit, the real interest rate you receive on your investment is 1% (3% – 2% = 1%).

Yet from 1978–82, real interest rates also more than doubled from 1.9% in 1978 to 8.2% in 1982.

Foster continues:

Then in the late 1980s, rates rose swiftly, and the market stayed roughly flat [so too did real rates].

What makes this even more fascinating is that America suffered a recession at this time because of the Federal Reserve’s restrictive monetary policy. By the time the recession ended, stocks were over 20% higher.

The bottom line? The tired refrain that rising interest rates hurt stocks needs to die.

So maybe monetary policy isn’t the cure for sky-high stock prices.

Maybe the only cure for high stock valuations is time. Sooner or later, valuations will climb too high and start to fall.

This is where investors with high cash reserves can really clean up. Yet, waiting for this perfect moment probably isn’t the best idea either. Who really knows what stocks will do in the next few months, let alone the next few years?

There are plenty of economists and fund managers out there taking educated guesses. But that’s all they’re doing…guessing.

You shouldn’t be scared to invest when valuations are high. Instead, be sceptical. Think about optimistic growth prospects and if they’re achievable. Question what economic growth might do in the next few months. Above all else, buy businesses that are cheap.

Until next week,

Härje Ronngard,
For Markets & Money

PS: You can still find value in the market. But do you have the time to pore through hundreds of companies each week? If you answered no, I highly recommend checking out Matt Hibbard’s advisory service, Total Income. He casts his slide rule across the entire ASX, looking for undervalued companies with the potential to grow dividends.

Not only do Matt’s stock tips deliver regular income streams, they have significant potential to see their share prices soar. Just a few of Matt’s recommendations are paying 9.60% and 11.73%. That’s more than four-times the yield you’d get on a 10-year Aussie government bond.

To find out more, click here.

Harje Ronngard is a Junior Analyst at Markets and Money. With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation. It’s not good enough to be right on average when it comes to investing. The market is volatile and it only takes one bad day to ruin your portfolio. You don’t want to end up like the six foot man that drowned in the river that was five foot deep on average. It’s why Harje is constantly reminding investors of their downside risk here at Markets and Money. He does so by simply asking just two questions.  What is it worth? And how much does it cost? These two questions alone open up a world of investment opportunities which Harje shares with Markets and Money readers. Right now Harje is focused on managing research and investments over at the Legacy Portfolio. An investment publication designed to significantly grow investor’s wealth over time with deeply undervalued businesses. Harje also contributes his insights in Total Income, headed by income specialist Matt Hibbard. Harje loves cash-rich businesses, so he feels right at home amongst Matt’s high yielding income plays.

Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money