The writer is a philanthropist, investor and economist
The legendary value investor Benjamin Graham once advised: “The habit of relating what is paid to what is offered is an invaluable trait in investment.”
Amid recent record highs in numerous stock market valuation measures, investors face a rare, possibly once-in-a-generation opportunity for the critical thinking that Graham encouraged.
Financial markets and economies are settings where the beliefs of individuals drive behaviours, collectively producing outcomes that then inform beliefs in turn. In the short-run, it may be irrelevant whether these belief systems are well-founded. In the longer run, the question is not optional.
Among the strongest elements of the belief system propping up record valuations and trading debt is the notion that central bank liquidity has the capacity to support elevated valuations indefinitely. Years of intervention have cast central banks as tools of self-reinforcing speculation. Mere phrases such as “Fed support” now suffice as complete investment strategies.
An example of this confidence is the near-universal assertion that record valuations in equity markets are justified by low interest rates. But what is meant by “justified”?
It is axiomatic that the higher the price one pays today for some set of future cash flows, the lower the long-term return one can expect. Elevated stock market valuations reduce future stock market returns. Record-low interest rates may “justify” record-high stock valuations, but only in the same way that poking your eye with a stick “justifies” smashing your thumb with a hammer.
The situation is worse if, as in recent decades, depressed interest rates are accompanied by below-average growth in gross domestic product and corporate revenues. Record valuations then merely add insult to injury.
It may be useful to critically examine the belief that central bank “liquidity” is a reliable mechanism for supporting market valuations. Central bank asset purchases operate by removing interest-bearing securities from private hands, and replacing them with zero-interest base money (bank reserves and currency). Like stock shares, bond certificates or any other security, once base money is created, it must be held by someone at every moment until it is retired by a central bank.
Central bank asset purchases “support” the equity market primarily by amplifying the discomfort of investors who must, in aggregate, hold this zero-interest base money. The moment one attempts to place this liquidity “into” the stock market, it immediately comes “out” via the hands of a seller. This liquidity is not “sitting on the sidelines” There are no sidelines. Base money can take no other form until it is retired.
Discomfort with low-interest liquidity can certainly amplify yield-seeking speculation in other assets, but only as long as investors expect higher returns on those alternatives. Yield-seeking speculation fuelled the bubble in mortgage securities and housing prices that ended in the global financial crisis, yet persistent Federal Reserve easing did little to halt that crisis once risk aversion took hold. Relaxing bank accounting standards on valuing assets in March 2009 did that. At record valuations, the markets are again reliant on the psychological willingness of investors to rule out the possibility of market losses.
Central bankers appear quite willing to disregard speculative valuations in pursuit of their “dual mandate” of inflation and unemployment. This adherence might be excused if activist monetary policy had large and reliable first-order effects on these economic variables, and only second-order effects on financial instability, instead of vice versa.
These concerns might be countered by observing that, in recent years, valuations have not mattered. Clearly, if overvaluation alone was sufficient to drive markets lower, one could never reach the extreme valuations observed in 1929, 2000 and today. The problem is that now investors require the markets to enjoy a permanently high plateau. Otherwise, valuations will matter profoundly.
In 1934, Graham and David Dodd described the errors that contributed to the 1929 extreme, and the collapse that followed. They observed that investors had abandoned attention to valuations in favour of prevailing trends, while “the rewards offered by the future had become irresistibly alluring”. Moreover, the backward-looking success of passive stock ownership had encouraged investors to ignore price as an investment consideration.
Graham and Dodd lamented: “It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.”