That would make sense if the increase in savings was expected to be mostly permanent. But in this case, the savings rate seems likely to revert to normal in a year or so. Why aren’t investors who see that selling enough now for stock prices to anticipate that return to normal?
My answer is that markets were fairly irrational in April, and have now mostly returned to expecting the economy to be back to normal in a year or two.
I see little reason to think that an unusually large fraction of stocks are overpriced.
However, I do see some puzzles when I look at a fairly select group of stocks with high market capitalization:
Amazon
Salesforce
Apple
Microsoft
Home Depot
Chipotle Mexican Grill
These and a modest number of similar companies have suspiciously high p/e ratios, and are big enough that a few dozen of them can be enough to make the S&P 500 overpriced, even if the majority of small-cap companies are underpriced.
Their prices are now saying that the pandemic did not cause harm. However, that might just be a continuation of a strange trend that was in place before the pandemic.
These stocks remind me of the Nifty Fifty of 50 years ago. Investors seem likely to be overconfident in these stocks, much as they were 50 years ago.
I also see some puzzles when I compare US stocks to other countries. Why do US stocks have high p/e ratios, high price/book ratios, etc, compared to countries which have handled the pandemic competently?
That would make sense if the increase in savings was expected to be mostly permanent. But in this case, the savings rate seems likely to revert to normal in a year or so. Why aren’t investors who see that selling enough now for stock prices to anticipate that return to normal?
When one stock is overvalued relative to another stock, investors can buy the undervalued and sell the overvalued. When the entire market (including bonds) is “overvalued”, that doesn’t work—there’s nothing to substitute into, and even an “overvalued” stock/bond is usually better than plain cash.
The relative price of two financial assets is mainly about expectations. The overall price level of the market is mainly about supply/demand of capital right now.
I’d be curious to know what you think about the theory Fed asset purchases are driving the market.
The link between Fed balance sheet and stock prices isn’t tight, but there seems to be a fuzzy connection—stock returns were higher than long run average during QE1-3, then went sort of sideways for awhile after 3 ended, after 2016 the global economy was on a better footing and stocks rallied until QT ramped up enough to matter, draining liquidity and the 4Q18 “correction” followed by resumed rallying coincident with “stealth QE” to mitigate illiquidity in the repo market. Then we got the C19 sell off, followed by QE4 > QE1+2+3 and stocks are ripping again.
The transmission mechanism is obviously not banks using the cash to buy equities, but rather increased availability of credit lowerIng the cost of borrow for leveraged investors. When liquidity was draining, it wasn’t a problem for until it hit a critical threshold where the cost to borrow no longer justified levering long for the marginal bet. At this point, someone decides it might be prudent to tighten up the risk exposure, which is effected by selling stocks and repaying lenders. In theory that ought to lead the cost of borrow to adjust down, but institutional changes after the GFC have made banks more risk averse and it’s possible, after the disruptions in the repo market, they decided to derisk too and a cascade ensues. Then the Fed buys $4tr of assets, the banks are flush with reserves, stock valuations are lower and so is the cost of borrow. This changes the calculus for leveraged funds (including derivatives related to equities like SPX futures) and they flip from net sellers of stocks to cut risk in the sell off and maintain margin requirements to net buyers.
Of course if we want to go all Ockham, money printing = devaluation → inflation causing real assets like equities to catch a bid.
This is also something I have yet to study in depth, but the Fed model makes a lot of sense (specifically the capital structure substitution version). Under that model, companies generally use stock issues/buybacks paired with bond buybacks/issues to adjust how much of their funding is from stocks vs bonds, in order to maximize expected earnings per share. That creates a transmission mechanism between bonds and stocks, and is the main thing I’d think about for the sorts of stuff you’re talking about.
More generally, I’m on board with Cochrane’s money as stock theory, although I think he doesn’t implement it quite right—the assets backing dollar value on a day-to-day basis are the SOMA portfolio, not the whole government’s assets and cash flows.
“money printing = devaluation → inflation”—that is kind of obvious—I would start with asking what are the arguments against it. In 2008 it did not work that way—so it looks kind of disproved, but times are changing. The Ray Dalio recent blog posts suggest that the USD global reserve status might be at the end of its cycle. Another thing is that the US government debt it increasing and at some day it will reach one of two reinforcing thresholds: one where investors would start seeing it as dangerous (and demand higher rates) and the other where servicing that debt becomes burdensome and the US government would have to devalue it.
I pretty much always expect positive total returns from stocks. Nothing in the OP contradicts the EMH—predicting crashes in such a way that we could profit from it is still Hard. The correct discount rate to use in EMH pricing depends on capital supply and demand, but that discount rate is still generally positive. Just like high bond prices mean that the yield is close to zero, not negative, high stock prices mean that expected returns are close to zero, not negative. (This isn’t always the case—e.g. negative interest rates in the European banks’ overnight markets during the previous decade—but that requires some fairly unusual conditions to maintain.)
So, yes, I do expect positive total returns from stocks over the next few months, though not very high on average and with quite a bit of variance.
Do you make any adjustment on the PE evaluation, particularly for the top 4, in light of all the ways reported earning can be manipulated. I have not looked but would you have the same list if looking at things from a revenue based valuation or a free cash flow valuation?
When I mentioned p/e ratios, that was just a hasty simplification, not a description of how I generated the list. I looked at a variety of indicators, including free cash flow, revenues, forecasted earnings, and dividends. For Amazon and Salesforce, GAAP earnings imply extreme overvaluation, but are a bit misleading, and free cash flow provides a better measure (they still look overpriced, but not dramatically enough that I’m eager to short them). For the other 4 that I listed, p/e ratios look about as informative as the other measures.
That would make sense if the increase in savings was expected to be mostly permanent. But in this case, the savings rate seems likely to revert to normal in a year or so. Why aren’t investors who see that selling enough now for stock prices to anticipate that return to normal?
My answer is that markets were fairly irrational in April, and have now mostly returned to expecting the economy to be back to normal in a year or two.
I see little reason to think that an unusually large fraction of stocks are overpriced.
However, I do see some puzzles when I look at a fairly select group of stocks with high market capitalization:
Amazon
Salesforce
Apple
Microsoft
Home Depot
Chipotle Mexican Grill
These and a modest number of similar companies have suspiciously high p/e ratios, and are big enough that a few dozen of them can be enough to make the S&P 500 overpriced, even if the majority of small-cap companies are underpriced.
Their prices are now saying that the pandemic did not cause harm. However, that might just be a continuation of a strange trend that was in place before the pandemic.
These stocks remind me of the Nifty Fifty of 50 years ago. Investors seem likely to be overconfident in these stocks, much as they were 50 years ago.
I also see some puzzles when I compare US stocks to other countries. Why do US stocks have high p/e ratios, high price/book ratios, etc, compared to countries which have handled the pandemic competently?
When one stock is overvalued relative to another stock, investors can buy the undervalued and sell the overvalued. When the entire market (including bonds) is “overvalued”, that doesn’t work—there’s nothing to substitute into, and even an “overvalued” stock/bond is usually better than plain cash.
The relative price of two financial assets is mainly about expectations. The overall price level of the market is mainly about supply/demand of capital right now.
I’d be curious to know what you think about the theory Fed asset purchases are driving the market.
The link between Fed balance sheet and stock prices isn’t tight, but there seems to be a fuzzy connection—stock returns were higher than long run average during QE1-3, then went sort of sideways for awhile after 3 ended, after 2016 the global economy was on a better footing and stocks rallied until QT ramped up enough to matter, draining liquidity and the 4Q18 “correction” followed by resumed rallying coincident with “stealth QE” to mitigate illiquidity in the repo market. Then we got the C19 sell off, followed by QE4 > QE1+2+3 and stocks are ripping again.
The transmission mechanism is obviously not banks using the cash to buy equities, but rather increased availability of credit lowerIng the cost of borrow for leveraged investors. When liquidity was draining, it wasn’t a problem for until it hit a critical threshold where the cost to borrow no longer justified levering long for the marginal bet. At this point, someone decides it might be prudent to tighten up the risk exposure, which is effected by selling stocks and repaying lenders. In theory that ought to lead the cost of borrow to adjust down, but institutional changes after the GFC have made banks more risk averse and it’s possible, after the disruptions in the repo market, they decided to derisk too and a cascade ensues. Then the Fed buys $4tr of assets, the banks are flush with reserves, stock valuations are lower and so is the cost of borrow. This changes the calculus for leveraged funds (including derivatives related to equities like SPX futures) and they flip from net sellers of stocks to cut risk in the sell off and maintain margin requirements to net buyers.
Of course if we want to go all Ockham, money printing = devaluation → inflation causing real assets like equities to catch a bid.
This is also something I have yet to study in depth, but the Fed model makes a lot of sense (specifically the capital structure substitution version). Under that model, companies generally use stock issues/buybacks paired with bond buybacks/issues to adjust how much of their funding is from stocks vs bonds, in order to maximize expected earnings per share. That creates a transmission mechanism between bonds and stocks, and is the main thing I’d think about for the sorts of stuff you’re talking about.
More generally, I’m on board with Cochrane’s money as stock theory, although I think he doesn’t implement it quite right—the assets backing dollar value on a day-to-day basis are the SOMA portfolio, not the whole government’s assets and cash flows.
“money printing = devaluation → inflation”—that is kind of obvious—I would start with asking what are the arguments against it. In 2008 it did not work that way—so it looks kind of disproved, but times are changing. The Ray Dalio recent blog posts suggest that the USD global reserve status might be at the end of its cycle. Another thing is that the US government debt it increasing and at some day it will reach one of two reinforcing thresholds: one where investors would start seeing it as dangerous (and demand higher rates) and the other where servicing that debt becomes burdensome and the US government would have to devalue it.
Wait, are you expecting positive total returns from stocks over the next few months? If so, this is very non-obvious from your post.
I pretty much always expect positive total returns from stocks. Nothing in the OP contradicts the EMH—predicting crashes in such a way that we could profit from it is still Hard. The correct discount rate to use in EMH pricing depends on capital supply and demand, but that discount rate is still generally positive. Just like high bond prices mean that the yield is close to zero, not negative, high stock prices mean that expected returns are close to zero, not negative. (This isn’t always the case—e.g. negative interest rates in the European banks’ overnight markets during the previous decade—but that requires some fairly unusual conditions to maintain.)
So, yes, I do expect positive total returns from stocks over the next few months, though not very high on average and with quite a bit of variance.
Do you make any adjustment on the PE evaluation, particularly for the top 4, in light of all the ways reported earning can be manipulated. I have not looked but would you have the same list if looking at things from a revenue based valuation or a free cash flow valuation?
When I mentioned p/e ratios, that was just a hasty simplification, not a description of how I generated the list. I looked at a variety of indicators, including free cash flow, revenues, forecasted earnings, and dividends. For Amazon and Salesforce, GAAP earnings imply extreme overvaluation, but are a bit misleading, and free cash flow provides a better measure (they still look overpriced, but not dramatically enough that I’m eager to short them). For the other 4 that I listed, p/e ratios look about as informative as the other measures.