A Theory of Persistently High Equity Valuations

There have been numerous theories offered to explain why equity valuations have continued to remain well-above their long-term historical averages.  Among them are:

The ability to defer taxation on equity investments through retirement plans

-The dramatically lower costs associated with investing (see here and here)

The evolution of the stock market from highly cyclical, lower-margin industrials to technology and healthcare

Another theory, argued by Philosophical Economics, argues that current low returns on cash induce equity holders to continue to buy into expensive equities, perhaps because they lack any appealing alternatives:

“It’s important to remember that as long as cash is yielding zero or something very low, there’s no arbitrage to force asset prices lower, no dynamic to force them to conform to some historically observed level or average.”

I cannot agree with this assertion simply because I do not think the weight of evidence supports it.  For example, cash returns, as measured by T-bill rates, have been almost as low and for just as long at prior times in history, such as the 1930s, but equity valuations continued to remain depressed as evidenced by persistently high earnings yields (the inverse of the P/E ratio):

Furthermore, even if investors today were stymied by low cash returns domestically, they can go abroad much easier than ever before, either to invest in high-yielding deposit accounts and bonds, or by investing in cheaper equity markets that, theoretically, should offer better long-term returns.  In addition, an examination of Europe and Japan, where rates are still much lower than in the US, and indeed negative in many instances, reveals that equity multiples are well below what can be seen in the United States, which to me indicates that the “there is no alternative to stocks” argument is insufficient in explaining higher equity  multiples.

In my opinion, to understand better why equity valuations are persistently higher than in the past, we must first remind ourselves what exactly equities are.  Essentially, a stock price today reflects the net present value of what investors expect from the company’s future cash flows.  This is often condensed into ratios such as the price-to-earnings and price-to-sales ratios that tell us how much of a premium a stock trades to its share of the company’s performance.

The two main variables in discounting these cash flows are the growth rate of a company’s earnings, and the prevailing inflation rate.  Obviously, if inflation is higher and is believed to remain higher into the future, then future cash flows are worth less today, so it follows that valuation multiples will fall, and earnings yields – the inverse of the P/E ratio – will rise.  The logic is no different from a bond investor who demands a higher current yield to own a bond in inflationary times.  You can see in the graph below how closely both the earnings yield on stocks and the yield on government bonds track inflation:

A longer-term chart reveals just how important inflation expectations are to equity valuation as evidenced by how close the earnings yield rate tracks the inflation rate:

For a variety of reasons, inflation has not only become more benign, it has become more stable.  From 1872 through 1949, inflation averaged around 1-2% annually, but that included multiple periods of deflation.  Since 1950, inflation has averaged around 3.5%, but the volatility in the series has been dampened considerably:

It should not be surprising, then, that during the volatile years from 1872-1949, when inflation fluctuated from as low as -10% to as high as almost 20% that equity price-to-earnings multiples traded at a 20% discount to the average levels observed during the far more stable period from 1950 to 2016.

That leaves us with the second part of the equity equation:  growth of corporate profits.  For a variety of reasons, business cycles in the United States have greatly moderated since the end of World War II.  The transition first from an agricultural economy in 1900 to an industrial economy in 1945 coincided with lower growth, but also shallower downturns.  Columnist George Will noted that even the 2008-2010 recession of -5% was minor compared to what transpired regularly before the Second World War, when there were “three contractions of 5 percent of GDP, two of 10 percent, and two of 15 percent*.”  Will also noted that, as the modern economy is now primarily service-based, expansions have become longer as evidenced by the fact that from 1945-1982, the economy was in recession almost one out of every four months, while from 1982 – 2007, the economy was in recession less than 5% of the time.

It goes without saying that longer expansions and shallower downturns – even if they do not produce as much growth as the more dynamic and disruptive cycles of the past –  mean more consistent earnings cycles for corporations, likely reducing the discount rate investors would otherwise apply to their investments, all of which means multiples should remain higher than they would in an economy in which business cycles were much more pronounced.

Finally, less dynamic business cycles have aided corporate profits in another way:  there is less competition for existing firms.  It seems counter-intuitive, but many great corporations were founded in recessions.  As they are naturally disruptive, recessions tend to weed-out weaker players in the marketplace through more rigorous competition.  Conversely, prolonged expansions tend to favor incumbent firms entrenched in increasingly concentrated industries, which allows for margins to remain expanded, and profit cycles to be more stable and consistent.  It seems logical that investors would be willing to pay more for the shares of companies that face little competition in a low-inflation, moderate-growth environment.

This is of course an oversimplification, but I really look to no other reasons why equity valuations have persisted at high levels for so long than that the business cycles on which corporate profits depend have become longer and less volatile, and the rate at which those profits are discounted – inflation – has become far more stable if not benign.  Investors today should ask themselves if they think low inflation and moderate growth are here to stay, or if there is a chance economic dynamism and higher inflation will return.  One thing seems to be certain, however:  today’s valuations do not leave much room for error.

*”The Hidden Costs of Recession.” – George F. Will Townhall.com 2008

Note:  Earnings yields shown are calculated based off of last twelve months’ P/E ratios provided by Multpl.com.