Takan Ada Lagi: Here’s an Argument That Stocks Should Be Even Higher

June 25, 2020 1:24 pm ET

Why aren’t stocks even more expensive? Before you splutter into your coffee, yes, I know that valuations are already the highest since the dot-com bubble. But with zero interest rates locked in and Treasury yields on the floor, financial models could support much higher valuations for the safest stocks.

Stripping out the equations, the argument is that the current price anticipates future earnings or dividends, with a discount applied to reflect both the cost of money and the risks. The lower the discount rate, the higher the future value of earnings. And the cost of money part of the discount rate—in essence the bond yield—has never been lower.

Christopher Rossbach, chief investment officer of London fund manager J. Stern & Co., says this more than justifies the high valuations of stocks with reliable dividends and solid, if unspectacular, growth—and he is a buyer even at what look like historically elevated prices.

“Every day that goes by is another missed opportunity to buy Nestlé, ” he says.

Because he expects the Swiss food giant to keep growing faster than inflation, he says a fair valuation is 50 times earnings, assuming interest rates return to what once counted as normal. If they stay depressed, it could be even higher.

He doesn’t expect Nestlé’s valuation to soar from its current 23 times the next 12 month’s estimated earnings, but doesn’t rule it out. And being able to justify a much higher valuation makes him unbothered by the worries that assail many over the U.S. market’s high multiples.

So why isn’t the valuation even higher?

“People get altitude sickness,” says Edward Bonham-Carter, vice chairman of Jupiter Asset Management.

Put another way, the models don’t work well when rates are low. The farther out we go in the future, the bigger the risks that something unthinkable happens—simple things like new technology, taxes and capital controls, or major events such as nationalization, wars or hyperinflation. The lower the discount rate, the further out in the future we have to think, but the models don’t reflect this.

Discount future earnings at 10%, and $100 of earnings in a century’s time is irrelevant, worth less than a penny today. Discount at 1%, and $100 in 2120 contributes $37. Discount it at 0.1%—not much of a change in the rate—and that future money is suddenly equivalent to $90 of earnings today.

Small changes in interest rates have a much bigger impact on the models when rates are low, making earnings far in the future matter more for stock prices. But that justifies a higher risk premium, because risks far out in the future become more important too—and history is littered with catastrophes that were unimaginable even a few years before, let alone decades. Fat profit margins are nibbled at by new competitors, innovative businesses stagnate or, as is beginning to happen with the big technology stocks, regulators step in. Unforeseen political or technological changes should be more of a risk on a multidecade view, too.

Investors tend to ignore these far-out risks, though, in favor of the obvious. The risk premium soared as the coronavirus’s hit to the economy became obvious, then shrank as the Federal Reserve and government stepped in to provide support. In the eurozone the risk premium has risen so much in the aftermath of its near-breakup in 2012 that it has offset negative rates (if the risk premium didn’t offset the negative rates, an overall zero discount rate would imply infinite prices, breaking the model).

The implied risk premium itself isn’t observable, being what is left after the cost of money and estimated earnings or dividend growth are plugged into a model with the current price. Even the cost of money is debatable (10-year Treasury yields? Inflation-adjusted yields? The hidden risk-free rate that underlies the bond yield?) and the estimates for earnings and the growth rate are informed guesses at best.

We can simplify it all by taking the consensus estimate for the earnings yield—future profits as a percentage of the price—and subtracting the Treasury yield. Using 18-month estimated earnings to try to strip out the temporary effects of the lockdowns, this gauge of the risk premium is back down to well within the range of what counted as normal since the 2008-9 financial crisis for both ordinary Treasurys and inflation-adjusted yields.

Federal Reserve Chairman Jerome Powell. The risk premium soared as the coronavirus’s economic hit became... — Federal Reserve Chairman Jerome Powell. The risk premium soared as the coronavirus’s economic hit became obvious, then shrank as the Fed and government stepped in to provide support.
Photo: kevin lamarque/Reuters

The battle between the Fed and growth prospects explains a lot of what has been going on in the market. The benefit of cheap money is more than offset by weaker growth for those companies hurt by lockdown restrictions or reliant on economic growth. Stocks that can promise earnings growth whatever the economy does and might even benefit from lockdown—providers of food, social media, online deliveries—get the benefit of the discount rate without any offset.

Assuming that the U.S. economy can overcome the rising infection rates in southern states, a falling risk premium could combine with continued cheap money from the Fed to support much higher valuations. They might be theoretically justified, and quite different from the dot-com bubble period when interest rates were much higher. But I would worry that they mean putting far too great a value on earnings impossibly far in the future.

Takan Ada Lagi

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Thursday, June 25, 2020

Here’s an Argument That Stocks Should Be Even Higher - The Wall Street Journal

Federal Reserve Chairman Jerome Powell. The risk premium soared as the coronavirus’s economic hit became obvious, then shrank as the Fed and government stepped in to provide support.

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