The Siren’s Song

In the current rate environment, we keep hearing arguments that low interest rates justify high stock market valuations because of the competing assets concept (i.e., the relative yields on stocks vs. bonds) and because discounting cash flows at lower rates results in higher present values. The factual nature of the math of the latter point notwithstanding, these arguments, however common, fall flat.

For one, stocks and bonds may be competing assets, but yield alone is a terrible way to evaluate the tradeoff, because the risk profiles aren’t even close to being equivalent. As I doubt that statement will be received as even remotely controversial, I’ll leave it at that.

But the siren song of the discounted cash flows argument is worth digging into a bit more. Investors put money in equities in part because they are a good inflation hedge over time. Why is that? If inflation is high or increasing, nominal earnings growth will likewise be high or increasing (although that isn’t necessarily true of real earnings growth), and if inflation is low or declining, nominal earnings growth will follow the same pattern. If stock prices follow earnings, which are nominal numbers, all else equal, valuation levels shouldn’t be affected, as both the P and the E adjust to the changing environment.

Additionally, all of the data we’ve ever seen on starting valuations and subsequent returns over longer periods of time indicates that there is a strong relationship. No matter what is driving interest rates up or down, high P/Es generally portend low future returns and vice versa. Rates are low and P/Es are high, and that means you shouldn’t count solely on your long-only equity positions to do all of the heavy lifting in the coming years. If your curiosity tempts you to listen to the ladies on the rocks, just make sure you tie yourself to the mast first.