“Why are stock market prices so high?”
That’s what well-known value fund manager Jeremy Grantham asks in his latest newsletter.
His answer is not very flattering.
Buy high, sell low – it’s etched into our DNA
Life has been frustrating for value managers over the last decade or so. Put simply, buying cheap stocks has been a losing trade compared to just buying whatever is going up this week.
So you can see why Jeremy Grantham, founder of US asset manager and value specialist GMO, might be a little bit irritated right now.
In his latest quarterly newsletter, some of that irritation shows. “Why are stock market prices so high?” It’s basically because investors are daft.
The thing is, this isn’t just a rant. Grantham has a very convincing point. He and his colleague Ben Inker have come up with a behavioural model of valuation that pretty much explains bubbles and busts going back for 100 years at least.
Here’s the starting point. Corporate profit margins are reverting to the mean. This has held true in the past, and you would expect it to. That’s because the mean reversion of profit margins is a critical component of free market capitalism.
The theory is that in a properly-functioning market, if one sector makes much higher profit margins than another, then entrepreneurs will swarm all over it. They compete with each other and undercut each other and do things more efficiently, until they’ve eroded each others’ margins back down to normal levels (and then more than likely undershooting to the downside).
Or there’s plain old cyclicality. People need more metal to build stuff. The metal price goes up. Miners dig up more of the metal. They make lots of money. They dig more holes. Suddenly there’s too much metal. The price goes down. Miners go bust. There’s no more metal. The price goes up. Someone digs a hole and finds more. And so on, and so on.
This is pretty much the point of markets – efficient resource allocation, directed via a pricing mechanism that summarises all relevant supply and demand information from every interested party.
So let’s assume that profits are mean-reverting. They have been in the past. If that’s the case, then investors should be willing to pay more for companies when margins are low. Because they’re going to rise in the future, and thus the companies will make more profits. If you expect future earnings to rise, you should be willing to pay more for them.
Similarly, if margins are at record highs, investors should be more cautious of overpaying for earnings. Because history suggests that they are very likely to go down. If you think a company’s earnings are going to fall, it’s daft to buy their stocks on a price/earnings ratio (p/e) of 25, for example.
Yet that’s not how it works. As Grantham puts it: “In real life… even in the past when margins were provably very mean-reverting, the market has always preferred high margins.” P/es are high when margins are high, and they’re low when margins are low.
“In 1974 or 1982, for example, at cosmic market lows, very, very depressed margins would sell at equally depressed p/es of 6x or 8x.” Meanwhile, “at market peaks like 2000, record margins were multiplied by record p/es.”
Stock market investors also hate inflation, “despite a history of stocks proving that their fundamentals are robust in the longer term in passing inflation through to consumers. Stocks, unlike bonds, are clearly real assets, so inflation should not matter.”
But again, in real life, when inflation “appears or accelerates, there is an immediate, coincident negative effect on p/e multiples.”
Grantham’s point is that investors are pro-cyclical. Which is a tactful way of saying that they are pathologically irrational. Which is a grand way of saying that they’re as thick as mince.
The real problem with zero interest-rate policy
Intuitively, this makes a lot of sense. People like stability. And they like high profit margins. It makes them feel good. And when they feel good, they’ll pay more money for stocks. It’s irrational – because you’re not meant to buy high, you’re meant to buy low – but it’s very, very human.
And that’s what explains today’s high stock prices, says Grantham. Price/earnings ratios are high because profit margins are high and inflation is low. (It also helps that GDP growth is stable – investors don’t mind if growth is moderate, as long as it’s not too volatile.)
But what does that suggest for today? Well for a start, it means that “any large and more or less permanent decline in the market… would require an equally large deterioration in profit margins or increase in inflation or some combination.” And Grantham can’t see either of those happening imminently.
The galling thing for Grantham of course, is that if there’s a crash or even a correction at any time in the next 18 months, he’ll be pegged as the “last bear to throw in the towel”, and a contrarian indicator. That’s unfair. But it’s the way these things work, and I’m sure he’s aware of it.
What’s more interesting to me – and what matters more – is the question: what has kept profit margins high? And the answer – I suspect – has to lie with overly accommodative monetary policy.
You see, this wouldn’t matter so much if it was just a cyclical thing. Booms and busts are a fact of life. Investors buy at the top, they take a pounding, and the wiser ones learn not to do it again (the next boom still happens but it sucks in different investors).
Yet in keeping interest rates too low, central banks have allowed zombie companies to survive (which suppresses “creative destruction”). They’ve also made it more attractive to conduct financial engineering than to invest and create real productivity growth. And they’ve made it easier for huge companies to cement monopolistic or oligopolistic positions in the market, thus sustaining high profit margins.
In short, central banks are short-circuiting the efficient allocation of resources. That’s a major problem. If you destroy the pricing mechanism – if you skew the market so that no price is ever so high that it can’t go higher – then you effectively wreck the incentive scheme that encourages people to commit resources to solving the problems that need to be solved.
That’s bad news. Because you need all that to make capitalism work. Otherwise you just get cronyism, corruption and cartels.
If you want to know why people seem to be steadily losing faith in a system that has worked well to drag more people out of poverty than any other in the world or in history, then look to zero interest-rate policy.
If you want to know why Jeremy Corbyn is still managing to persuade people that the Venezuelan model could work – if they only tweaked it a little bit – then look no further than our central banks.
It may well all be done with the best intentions. But we all know which destination they pave the road to. We need to wake up to the fact that a fall in share prices or house prices is not the worst thing that can befall a society.