The mystery of the award

Good morning. I spent most of last week in Venice for the FT Business of Luxury Summit. I’m happy to report that only one participant fell into the gutter (he was fine), that the luxury industry remains in rude health (even if the wild post-pandemic boom is winding down), and that Tintoretto is on my personal list of greatest painters (Velázquez and El Greco are still holds the first two places). Send me your top 5: robert.armstrong@ft.com.

The mystery of the award

Something happened to the valuation of American stocks about thirty years ago. Consider, as just one example, Robert Shiller’s cyclically adjusted PE ratio (PE) (the price of the S&P 500 divided by its 10-year average earnings). Until 1995, it looked like a well-behaved mean-reverting series, where the average was about 15. Since then, it’s looked like a somewhat more volatile but still mostly mean-reverting series, where the average is about 28:

If you believe that valuations are an important, if imprecise, indicator of long-term returns (as I do), this is important and concerning. Even if you’re ready to concede that something about valuation changed thirty years ago (as many value investors try to do), the fact that it changed requires an explanation. If you don’t understand that, how can you know that the next change isn’t coming, or isn’t already here? Granted there is a statistical relationship between valuations and long-term returns (some think there isn’t), if you don’t understand why that relationship changes over time, it would be foolish to use it for decision making.

I’ve been thinking about this problem for an embarrassingly long time without coming to any particularly solid or useful conclusions.

My best guess was that what changed was inflation. When valuations were lower, inflation was generally higher and, more importantly, less stable. Stocks are often thought of as a hedge against inflation, but this is only partially true. High and unstable inflation (and all high inflation is unstable) makes life difficult for firms, dampens real growth over time, and can contribute to recessions. It makes sense that persistently higher inflation should be associated with lower stock valuations. Unfortunately for this theory, we have just experienced the biggest increase in inflation in 40 years, and valuations have only increased. That doesn’t mean we have to discard the idea entirely. Inflation expectations have generally remained in check over the past few years, and expectations are almost certainly important to valuation because stocks are such a long-duration asset. Still, 10-year inflation expectations under the Cleveland Fed’s model were around 2 percent before the pandemic and are now around 2.5 percent, and valuations don’t matter much.

Another possibility is that the last few decades have been really strange. They introduced two epic bubbles, a once-in-a-lifetime financial crisis, a revolution in monetary policy, and a global pandemic. Perhaps it would be unrealistic to expect any market regularities to hold in such a storm and old patterns to eventually reassert themselves. There may be something to it, but looking at a 30-year period and declaring it anomalous is a bit more than the social scientist in me can bear.

Shiller himself was annoyed that for many years his Cape ratio was very high while stocks were rising higher and higher. His solution was to adjust interest rates. Its “excess Cape yield” (ECY) is the inverse of the Cape multiple, expressed as a percentage, minus the real 10-year Treasury yield. Since this is a yield rather than a multiple, a higher ECY means the stock is cheaper. And historically, ECY seems to do a pretty good job of signaling good and bad times to buy stocks. This means that while when Shiller first introduced the ECY in 2020, the S&P 500 looked more reasonably priced than the classic Cape ratio, that is no longer the case as rates have risen sharply and stock prices have also risen. As with the Cape, there are completely different ECY regimes before and after the 1990s. Previously, the average ECY was about five percent; now it’s half that level (and right now ECY is at a nasty 1.2 percent).

In a recent post, blogger and former stock strategist Jim Paulsen offered five interesting explanations for the shift in the Cape ratio:

1. Economic cycles became milder: “From 1854 to World War II, the US was in recession 42 percent of the time. Since 1980, it has only been in recession 11 percent of the time. Arguably, when one of the biggest risks for equity investors, recessions, occurs less often, valuations can and should expand.”

2. The makeup of the market has changed, with faster-growing technology companies making up a larger portion of it: “Since the 1980s, the US has enjoyed a rapid pace of modernization, including fiber optics, cell phones, computers, the Internet, and social networks. media, streaming services and now AI . . . innovations have always received higher multiples because much of their value is based on future business growth. . . growth stocks have always received higher PE multiples compared to cyclical stocks.”

3. The market is now more liquid: “It not only has individual [market] participation has improved substantially, but international investors have also expanded. Technological advancements have also improved liquidity as electronic trading now makes investing much easier. As with any individual stock, when liquidity improves, volatility decreases and valuations rise.”

4. “Profit productivity,” or real earnings per worker, rose. “Since 1940, there has been a close relationship—a correlation of +0.69—between the stock market PE multiple and earnings productivity. What is most remarkable about this relationship is that when the stock market was in its old stable valuation range, profit productivity was also in its stable range. When earnings productivity broke that range in 1990 and has risen sharply since then, stock market valuations also broke through their old range and stayed higher.”

I think the first two ideas are compelling and interesting and the third and fourth are not. Starting with the parts I disagree with, I don’t see how the difference in liquidity between now and 30 years ago is enough to explain the significant movement in average valuations. Stocks are more liquid now, but back then you had daily liquidity, and on very bad days – the days that really matter – liquidity is still a problem today. It’s also worth noting that illiquid assets—private equity and debt—don’t trade at a significant discount in today’s market.

On productivity, I agree with Paulson that productivity is the most important thing in the sense that it is the most important driver of growth for both economies and businesses. However, from an investor’s point of view, it is the amount of profit and the growth of profit that is important, not their drivers. At best, an explanation of valuation based on higher productivity is reducible to an explanation based on higher growth. If productivity growth is good for valuations, it’s because it means a higher growth rate.

This leads us to Paulsen’s second point, that the market now contains more growth stocks. This explanation makes a lot of sense, but it makes me a little nervous because I think growth rates are very hard to predict. If asset prices are the present value of future cash flows, higher future earnings growth, other things being equal, must be reflected in a higher valuation. And if we look at the current crop of huge, dominant growth companies and their strong market positions, it’s easy to think that their growth rates will continue. However, history teaches us that dominant positions in markets, including technology markets, can disappear relatively quickly (General Electric, IBM, Nokia and others). It’s possible that today’s tech companies enjoy a semi-permanent “increasing returns to scale” dynamic that will help their growth last longer than companies of the past. But I’m just not sure.

That leaves Paulsen’s final point that the economy is now more cyclical. I agree with Paulsen’s instinct that the worst economic moments matter most to investors. It is in recessions that companies are most likely to fail, that margin challenges tend to occur, and that panic selling destroys portfolios. But then again, have the last 30 years, with their bubbles and busts, really been that quiet — quiet enough to justify a doubling in valuations? Perhaps modern central banking has taken the brunt of the economic cycle, but again, I’m not sure.

Appreciation matters. The idea that the price you pay for a financial asset does not depend on the future returns on that asset is a non-starter. But how best to measure valuation and how best to feed those measurements into decision-making remains a very tricky question.

One good read

Rent regulation does not solve the housing crisis.

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