Monday, March 17, 2014

More on Philosophical Economics' "The US Market Is Expensive and It Should Be"

To reiterate the link:

Philosophical Economics - the US stock market is expensive and it should be. Hopefully you already read it, then said "hey this guy is really good", then printed it out and taped it to your monitor for future consultation. I'll just quote some bits and add tangential commentary:

The typical market before the tech-bubble was priced to offer very attractive returns, with a median P/E of around 13 times trailing earnings. The current market, at around 17 times trailing earnings, is priced much more richly. But this doesn’t mean that the current market is priced incorrectly. It doesn’t mean that a mistake is being made, and that you should therefore hunker down in cash and wait for the situation to get “corrected.” There’s an excellent chance that nothing is going to get corrected, that you’re going to continue to wait in vain forever, because nothing is wrong.

What really steams me about that guy we all know with the "P/E is expensive compared to the mean" blather is that he has no response to the obvious counter, which is "so how long will it take for the P/E to correct, and when do you expect this correction to start?"

I mean, if I'm supposed to make an investment decision on someone's expensive P/E call, that demands that he can time the P/E correction properly. A reversion to the mean will take time, and I can be killed waiting for the turn. So sorry, mister newsletter writer; if you're not giving me a timing prediction, your opinion is worthless.

And if you've sucked at timing the impending correction til now, I'm not even going to pay attention to you in the future.

But this is where the Philosophical Economics author gets really good:

Yes, the market is expensive relative to the past, but why shouldn’t it be? If markets are efficient, then equities cannot remain priced for historically attractive returns while all other asset classes are priced for historically unattractive returns. In such a scenario, every rational investor will choose to hold equities. But, as a rule, someone must always be found to hold the other stuff–including the cash. Equity prices will therefore get pushed up and implied returns pulled down. The market will seek out a new equilibrium in which relative valuations are more congruent with each other, and where it is easier to find a willing holder of every asset.

"If markets are efficient, then" is a statement that always gets me excited, because there's probably a good idea following it. In this case, it's the upshot of his entire argument: equity returns today still have to be repriced so that their future returns will be competitive with all other asset classes.

Serious, I feel like a chimp staring at a big black alien monolith here.

Over the next several years and decades, the Fed will likely find it difficult to ensure that adequate levels of investment and credit creation take place to match the desired level of savings in the economy. The only tool that it can adjust to achieve the required balance is the interest rate, and therefore the interest rate is almost certainly going to remain low relative to history. If you disagree, just look at what the market is saying: the 10 year treasury is at 2.65% for a reason.

And if rates remain low, equity prices have to go up to make their expected return roughly equal (when an appropriate equity risk premium is included, I'd expect).

Here's a restate of a previous point, just fleshed out:

Over the last 10 years, cash has returned roughly 1.5% annually. Over the next 10 years, those on the sidelines will be lucky to see cash match that average return. Who is the person that is going to opt to hold cash at a long-term return of 1.5% if stocks are priced to return their historical average of 10%? Certainly not me. Certainly not you. Not even the valuation bears. But then who? In the year 2014, is there anyone historically misguided enough to think that hunkering down in cash in such an environment is the right answer? In 1917, or 1942, a sufficient number of those people may have existed, enough to create an arbitrage opportunity for the rest of the market. But very few exist now. And therefore investors should not expect, as a matter of course, to be offered the historical average, 10%, in exchange for taking equity risk. It’s not a realistic expectation.

But then, I guess, that means stocks have to go up now in order to reduce that large future-return premium over cash. Thus, his thesis that it doesn't matter if stocks are "overvalued vs. earnings": stocks aren't in competition with a fantasy indicator, they're in competition with other asset classes. And they're a no-brainer buy right now, relative to cash or USTs. So shouldn't you expect them to go up?

Seriously, mister goldbug newsletter writer: if you are calling for a crash in stocks, where is that money supposed to flee to? Cuz knowing your politics, you're probably also calling for a crash in USTs, and you already know cash yields negative zero. So where is all the money supposed to flee to?


The other goldbug response is that the money simply disappears because it's all leveraged and make-believe: these guys are the Anti-Fractional-Reserve-Banking crowd, also known as the John Birch Society. Ignore them as well.

Next point:

Who cares if stocks offered a better return in the past than they currently offer? All that matters is what they are offering now, and what they are likely to offer in the future. We select from the options that are there, not from the options that used to be there, and especially not from the options that we think “should be” there in a moral sense.

Really, really, really important. This market is not the last market. Comparing this age to the 1940s is like fighting World War II with cavalry: you've made the mistake of trying to fight this war as if it was the last war.

The machine is different. Therefore the historical P/E chart does not chart the same entity over time.

He finishes with a broadside at that clown Hussman, who's (still?!?) calling for a 50% crash in the market despite the fact that this would mean that portfolios in the aggregate would need to radically change their allocation amounts:

Sure, the market could fall by 50% in a temporary panic, unrelated to valuation, as it did in late 2008 and early 2009. But for it to drop by 50% in a long-term valuation re-rating, a move that actually sticks, investors would need to undergo a sea change in portfolio allocation preference. They would need to want their equity exposures reduced to the record lows of the early 1980s, a period when the competition–cash and bonds–was yielding double digits. Right now, the competition is yielding virtually nothing.

Competition between assets for money? Valuation equilibrium across asset classes? Efficient markets?

This guy is great and you should read this article. I'm adding him to my RSS when I get the chance, he sold me.

1 comment:

  1. You should read Kid Dynamite's latest on gold, and the guy he links to who inspired the post, and that guy's comments section.