5i Research Blog
Mar 31, 2017 Why Markets May Not Be Expensive
One of the more consistent themes that the markets have seen over the last few years is the discussion on how overvalued the markets are. Meanwhile, markets seemed not to agree and have driven to all time highs. What is perhaps most interesting is that while there appears to be a consensus that markets are overvalued, they seem to continue to be strong.
So what is going on here?
How can everyone agree that markets are overpriced yet markets still remain so? Below we take a look not at whether markets are or are not overvalued, but why a higher valuation than we have seen in the past may be justified.
1) Ease of market access
Even just ten years ago, investing in stocks was much more difficult than it is today. Not everyone had access. Liquidity was lower, fees were higher and transaction costs were higher as well. All of these items add costs and risks that need to be justified with higher returns.
How does one get higher returns on average? By having a lower average valuation. As the frictional costs become smaller, valuations have more room to creep up over time. Access to information has also become cheaper which means that the returns needed to cover costs to access information have decreased.
2) Knowledge of equity premium
Much research has been done on the merits of investing in equities. As history of the stock market grows and markets seem to make it through one crisis after another, investors become more knowledgeable and aware of the benefits of investing in equities.
With more knowledge and comfort with the asset class, the less perceived risk exists. With less perceived risk, one can argue that less of a return is required for the risk being assumed. Looking past just North America, there are vast populations that are likely just at the early innings when it comes to understanding the benefits of investing, adding potentially substantial demand for stocks over the long-term.
3) Low rates and low inflation
When interest rates are low, opportunity costs are also low. Investors demand a rate above and beyond risk free rates. When these rates are low, the return required from stocks can be lower on an absolute basis (but still possibly be the same on a real basis). If lower returns are acceptable due to the low rates and the case that investors have nowhere else to invest, then higher valuations could be justified.
The same argument goes for low inflation. In times of 3% inflation or more, a higher return would be needed than in times of 1% inflation in order to have the same return in real terms. A 7% return with 3% inflation means a 4% real return (7-3=4). With 1% inflation, an investor only needs a 5% return to end with the same amount of money/return in real terms (5-1=4).
While inflation is likely to be more volatile going forward, there is likely an argument that interest rates may not just be lower for longer, but they may be lower indefinitely, helping to justify higher average valuations.
4) More competition
With more competition and more investors competing for scarce dollars, it could be argued that investors are willing to accept smaller returns because that is all that is available. Right when an opportunity appears, stocks can quickly correct back to fair value and stock valuations on average may be higher just because there are more eyes and more perfection in pricing.
This point makes me think of a piece that stuck with me a while back. While the linked article seems to be talking a bit more about the lack of market alternatives, the ETF trend that it touches on also could have some structural changes to the way investors look at valuations.
One smaller impact is the trend of fees. In the past, with funds charging you 2% or more to get exposure to a market, the returns required would have been higher. With ETFs now going for less than half a percentage point, there could be an argument that the average investor can deal with higher valuations on average (and in turn lower returns) because in real terms, after fees, they may be facing the same net return.
The other aspect to ETFs is that of the passive tsunami. Looking at some pretty astonishing stats on the headway the ETF industry is making, this notion becomes believable. The notion is simply that with passive investors throwing caution to the wind on valuation and (rightly) thinking longer term and just investing in the market, valuations get supported.
If passive investors do not care about valuation, then they are happy to continue to buy stocks and support higher valuations. As noted in the ‘Relentless Bid’, any sign of a downturn means the passive investor is getting a ‘deal’, and funds flow into the market at a hint of a pullback.
So in short, in a market where valuations very well may not matter to the long-term investor, higher valuations can be supported because over a 10-year, passive time frame, investors believe their portfolio will fare well. To be clear, we would largely agree with this notion of long-term investing and would be one of the last ones to argue the power of time when investing.
However, where the wheels may fall off is when any real downturn or prolonged recession occurs. While talking about passive investing over the long-term is nice, the passive investors that get in at the top may have a hard time sticking with the strategy when times get tough. Then the fear trade could very well work the opposite way and lead to an exodus. As the saying goes, talk is cheap and the passive movement has really just gotten started in what has largely been a bull market. The real test will be when the premium valuations get tested (if they ever do) and how the passive camp acts.
Passive conversation aside, all of these above points could very well justify a regime change in market valuations. While it does not mean that current valuations are either under or overvalued, it could mean the degree of under or over valuation that investors look at is less severe than feared.
Instead of markets at 20 times earnings being expensive against the average of 15 or 16 times, maybe they are a bit more reasonable if that long-term average is justified as being 18 or 19 times earnings. Unfortunately, no one will know what that right average is until five or ten years down the road.
You can see our previous thoughts on market valuations here.
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