The Federal Reserve has kept short-term interest rates at zero for more than five years. As a result, the yield on the U.S. Treasury 10 year note ("10 year note") dropped to a low under 1.50% in 2012. This initiative has been taken to avoid a depression -- to inflate the economy out of the great recession. The wealth effect from rising asset prices would kick start consumption. The economy would achieve escape velocity, at which point monetary easing could be withdrawn. We may be close to this inflection point.
I believe a dividend discount model to be the best way to determine the fair value for the Standard and Poor's 500 Index ("the stock market"). To me, fair value is the present value of the future dividend stream discounted to the present. The discount rate chosen for this calculation is vital. A higher discount rate implies a lower fair value; and vice versa.
The yield on the 10 year note is now "artificially" 2.60%. If one plugs a 2.60% discount rate into a dividend discount model, fair value would be much higher than the stock market's current price of 1972. Thus, the stock market would appear to be grossly undervalued. A well-known bond investor recently announced these low rates to be the "new normal". Thus, he suggests, this bull market has a long way to go on the upside. The phrase "new normal" reminds me of the most dangerous phrase in the Wall Street lexicon, "This time it's different!" With respect to what discount rate to use in a dividend discount model, I prefer the 10 year note yield averaged over a much longer period than five years.
Those of you who have been reading my posts know that I believe strongly in reversion to the mean. I seek to normalize earnings, earnings growth, and interest rates-- the most important variables determining fair value for the stock market when using a dividend discount model.
Professor Shiller at Yale has devised a method for normalizing earnings. For each of the last ten years, he adjusts each annual earnings for inflation, totals them, and divides by ten. Then by dividing the current price of the stock market by those earnings, he arrives at the market's adjusted price/earnings ratio. He calls it the CAPE ratio, an acronym for "Cyclically Adjusted Price Earnings" ratio. By dividing his current CAPE ratio by the historical average CAPE ratio, he arrives at the extent to which the market is overvalued or undervalued. (The CAPE numbers are available intraday by googling "Shiller's CAPE".)
With this methodology he eliminates the distortions arising from the profit margin cycle. I have argued that, all other things remaining constant, earnings above trend-line should have a lower than average price/earnings ratio, and vice versa. If one doesn't take the profit margin cycle into account, he is likely to buy high and sell low.
However, one major flaw in Shiller's CAPE ratio is that it fails to adjust fully for the level of interest rates. To test the effect of interest rates on CAPE, I have superimposed the chart of the 10 year note yield on the chart of CAPE over the last fifty years. (CAPE is in blue; Yield is in red.)
From 1964 to 1981, while the yield on the 10 year note rose from 4.2% to 15.2%, CAPE declined from 22.2 to 8.4. From 1981 to 2012, while the yield on the 10 year note declined from 15.2% to 1.5%, CAPE rose from 8.4 to 21.3. I conclude from this negative correlation over fifty years that interest rates have had a significant impact on p/e ratios.
Professor Shiller's data covers a 143 year period. My time interval is 50 years. Below are the various means over these two time periods.
CAPE 10 Year Note
Mean Mean
1871-2014 16.6 4.63%
1964-2014 19.6 6.64%
The CAPE ratio is currently 26.1, suggesting that the stock market is 57% overvalued based on the assumptions of a CAPE mean of 16.6 and the 10 year note mean of 4.63%. However, the current 10 year note yield, 2.60%, is more than 200 basis points below that of Shiller's interest rate mean. As long as interest rates remain so low, the bull market will continue. On the other hand, once inflation begins to rise and the Fed is forced to tighten, an upward move in rates to or beyond the 10 year note mean should result in CAPE's reverting to or below its mean. If that happens quickly, a bear market in stocks would occur.
Observations:
(1)The Fed, by keeping interest rates so low for so long, has heavily borrowed from future investment returns. A thirty year bull market in bonds probably ended in 2012. A secular bear market in bonds has probably begun. For those with very long horizons, such as Generation Xers, such a negative trend constitutes an enormous headwind for both bonds and stocks. The conventional asset allocations should be rethought. At the least, the duration of the fixed income portion should be significantly reduced. Some money should be taken out of stocks as well. The proceeds should be invested in non-correlating alternatives or kept in cash equivalents until mean reversions occur.
(2) For those of us who are retired with much shorter time horizons, the asset allocation decision becomes murky because it depends on how rapidly interest rates rise to the mean. If the adjustment is rapid, then both stocks and bonds would decline significantly. If a slow rise ensues, then the damage could be manageable. The problem is that we are in uncharted territory. Being risk averse, I would advise rebalancing the stock portfolio and placing the proceeds of stock sales into cash equivalents or very short duration treasury notes. The long duration bond portfolio should be eliminated, with the proceeds placed in shorter duration treasury notes. As I have said before, this strategy requires patience and discipline. It is not for everyone.
(3) If the economy stays in slow growth mode without any significant rise in inflation, then interest rates would remain low and the stock market could continue to appreciate. Hard to assign a probability to this occurrence.
(4) A slide into recession, a low probability at this point, would result in a serious downdraft in the stock market--probably as much as 30%. Bonds would appreciate in value even from these low interest rate levels.
On another subject, I intend to alter my rebalancing technique. Instead of rebalancing periodically, such as once a year, it makes more sense to rebalance according to overvaluation or undervaluation levels. That would mean that a melt up or melt down in the stock market could trigger rebalancing more frequently than once a year. I'm not predicting a melt up, but anything can happen.
Professor Shiller's data covers a 143 year period. My time interval is 50 years. Below are the various means over these two time periods.
CAPE 10 Year Note
Mean Mean
1871-2014 16.6 4.63%
1964-2014 19.6 6.64%
The CAPE ratio is currently 26.1, suggesting that the stock market is 57% overvalued based on the assumptions of a CAPE mean of 16.6 and the 10 year note mean of 4.63%. However, the current 10 year note yield, 2.60%, is more than 200 basis points below that of Shiller's interest rate mean. As long as interest rates remain so low, the bull market will continue. On the other hand, once inflation begins to rise and the Fed is forced to tighten, an upward move in rates to or beyond the 10 year note mean should result in CAPE's reverting to or below its mean. If that happens quickly, a bear market in stocks would occur.
Observations:
(1)The Fed, by keeping interest rates so low for so long, has heavily borrowed from future investment returns. A thirty year bull market in bonds probably ended in 2012. A secular bear market in bonds has probably begun. For those with very long horizons, such as Generation Xers, such a negative trend constitutes an enormous headwind for both bonds and stocks. The conventional asset allocations should be rethought. At the least, the duration of the fixed income portion should be significantly reduced. Some money should be taken out of stocks as well. The proceeds should be invested in non-correlating alternatives or kept in cash equivalents until mean reversions occur.
(2) For those of us who are retired with much shorter time horizons, the asset allocation decision becomes murky because it depends on how rapidly interest rates rise to the mean. If the adjustment is rapid, then both stocks and bonds would decline significantly. If a slow rise ensues, then the damage could be manageable. The problem is that we are in uncharted territory. Being risk averse, I would advise rebalancing the stock portfolio and placing the proceeds of stock sales into cash equivalents or very short duration treasury notes. The long duration bond portfolio should be eliminated, with the proceeds placed in shorter duration treasury notes. As I have said before, this strategy requires patience and discipline. It is not for everyone.
(3) If the economy stays in slow growth mode without any significant rise in inflation, then interest rates would remain low and the stock market could continue to appreciate. Hard to assign a probability to this occurrence.
(4) A slide into recession, a low probability at this point, would result in a serious downdraft in the stock market--probably as much as 30%. Bonds would appreciate in value even from these low interest rate levels.
On another subject, I intend to alter my rebalancing technique. Instead of rebalancing periodically, such as once a year, it makes more sense to rebalance according to overvaluation or undervaluation levels. That would mean that a melt up or melt down in the stock market could trigger rebalancing more frequently than once a year. I'm not predicting a melt up, but anything can happen.
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