Assuming that you could throw stones on the financial internet, it would be hard to toss a stone and miss articles talking about how high the stock market is. One good article from last week was Why Do U.S. Stocks Keep Hitting Records? Here Are Five Theories from the Wall Street Journal. Here were the five theories:
- Stocks Reflect the Resurgent Health of American Corporations
- The Global Outlook Is Looking Brighter
- The U.S. Economy Is in a ‘Goldilocks’ Situation
- Passive Funds Are Propping Up Prices
- There Is No Alternative
Of this list, I think answers 1, 3 and 5 are correct, and 2 and 4 are wrong. I have a few other answers that I think are right:
- Demographics are leading people to buy assets that will provide long-term cash flows. Monetary policy has led to asset price inflation, not goods price inflation.
- People are overestimating the resiliency of the political and social constructs that make all of this possible.
- The “Dumb Money” hasn’t arrived yet, but the sale of volatility by retail contradict that.
I disagree with point 2 from the WSJ article because a stronger global economy not only means that profits will rise, but also the cost of capital. Depending on which factor is stronger, a stronger global economy can make stocks go up, down, or be neutral.
On point 4, I’ve written about that in Overvaluation is NOT Due to Passive Investing. What matters more than the active/passive mix is the total shift in portfolio holdings into stocks versus everything else. When people hold a lot of their portfolio in stocks, stock prices tend to be high.
The active/passive mix does have effect on the relative prices of securities in the indexes versus outside the indexes. The clearest place to see the impacts of ETFs and indexing is in bonds, where bonds that are in the indexes trade at lower yields and higher prices than similar non-index bonds.
With stocks, it is probably the same, but harder to prove; I wrote about this here. In the short run, the companies in the popular indexes are getting a tailwind. That will turn into a headwind at some point, because the voting machine always eventually becomes a weighing machine.
Why are stocks high?
Profit margins are high because of productivity increases from the application of information technology. Also, there is a lot of lower paid labor to employ globally which further depresses wage rates in developed countries.
Points 3 and 5 of the WSJ article are almost saying the same thing. Interest rates are low. They are low because inflation is low,, and general economic activity is not that robust. As such, the cost of capital is low, people are willing to pay high prices for stocks and bonds relative to their cash flows.
Part of this stems from demographics, which was my first additional point. For those that are retired or want to retire, there aren’t a lot of ways to transfer money earned in the present so that you can get the equivalent purchasing power or better far into the future. There are a few commodities that you can store, like gold, but most can’t be stored. Thus you can buy bonds if you don’t think inflation will be bad, or inflation-protected bonds if you can live with low real returns. Money market funds will keep your principal stable, but also provide little return. You can buy stocks if you are willing to get some inflation protection, and run the risk of a rising cost of capital at some point in the future. Same for real estate, but substitute in rising mortgage rates.
A shift can happen when the marginal dollar produced by monetary policy shifts from being saved to being spent. For now, monetary policy inflates asset prices, not goods prices (much).
My second point says that people are willing to spend more on stocks when they think that the system will remain stable for a long time. That seems to be true today, but as I have pointed out before, it discounts the probability of trade wars, real wars, resurgent socialism, and bad future demographics. Nations with shrinking populations tend to have poor asset returns. Also, nations with unproductive cultures don’t tend to make economic progress.
My third point is equivocal. I don’t see a lot of people yelling “buy stock!” There’s a lot of disbelief in the market; this is what Jason Zweig was talking about in his most recent WSJ column. That said, when I see lots of activity from people shorting volatility through exchange traded products in order to earn returns, it makes me wonder. As I have said before, “Nothing brings out the financial worst in people like the lure of seemingly free money.” Eventually those trades sting those that stay at the party too long.
So, where does that leave me? The market is high, as my models indicate. It may remain high for a while, and may get higher still. That said, it would be historically unprecedented to remain in the top decile of valuations for more than three years. It would be healthy to have the following:
- A garden-variety recession
- A garden-variety bear market
- More varied sector/industry performance
Will we get any of those? I don’t know. I can tell you this, though. For now, my asset allocation risk is on the low side for me, with stocks at around 70% (that is high for most people, but that is how I have lived my life). If we get over the 95th percentile of valuations, I will hedge what I can. For now, I reluctantly soldier on.