What are Stocks Worth?

Over the ten days between January 29 and February 8, the world’s stock markets  decided that equities were actually worth about 10% less than they were at the close on January 26. Of course, on that date markets priced equities more than 20% higher than they were immediately before Trump’s election. So prices have varied plus-or-minus about 25%, as shown in the chart of the S&P 500 below.

SP500 Election - Feb18

In terms of market history, there is nothing unusual about the recent price action. On Thursday February 8 we had the largest-ever single-day point decline in the Dow Jones Industrial Average, but nowhere close to the greatest percentage decline. At the end of trading on Thursday, February 8 we were officially in a correction, defined as a 10% decline from a prior market close. Since the Second World War, the US stock market has seen a correction about every 14 months. Nothing much to see here, then, in terms of unusual market action. But there may be an opportunity for increased understanding in examining the stated reasons for the decline.

The main driver of the decline was a rise in inflation fears. About one-third of the commentators noted that higher inflation will cause the Fed to raise interest rates, and those elevated rates will choke off economic growth, thus the decline has a legitimate economic basis. Another third of observers agree that the fear of inflation is causing a fear of rising rates, but think both fears are premature, and should not distract us from the current bullish reality–a strong world economy and a solid near-term corporate earnings forecast.

Both the bull and bear cases are based on the theory that economic growth drives stock prices. That theory is mostly wrong. To understand this, consider the stock market’s performance during the Obama years. By all accounts, economic growth during the years 2009-2016 was slow, especially after a deep recession. Yet the US stock market was up about 300% during Obama’s watch.

Here’s my take on the drivers of valuation:

Growth in GDP is almost irrelevant, unless the economy collapses into recession. More directly consequential is…

Growth in corporate earnings, which has been much stronger than overall economic growth, as corporations have used pricing power in labor markets to increase their margins. Corporate earnings are at unprecedented levels as a fraction of GDP. Earnings are the denominator in the pricing calculation, but the future streams of earnings and dividends we buy as stock investors are actually less important than…

The price we pay for them. There are three principal determinants of the price/earnings ratio. The least important is…

The prospective returns on competing investments. If Treasury bond yields were to rise to 6.5%, utility stocks (for example) would need to decline in price to remain competitive. This mechanism (direct and immediate competition for investor dollars) is way more important than the delayed, indirect, and hypothetical effect of higher interest rates on future economic growth, but still less important than…

Sentiment. Greed can drive markets upward much further and faster than any underlying change in the real economy, while fear can crater prices out of all proportion to actual economic declines. Earlier this month, stock prices fell by 10% in less than a week, but the US economy hasn’t seen a year-over-year decline in GDP of 10% since the 1930s. Sentiment-driven pricing changes can be abrupt and significant, but they are not structural. Which brings us to the most powerful driver of stock valuations…

Inflation. Contrary to the discussion in recent weeks, inflation is not an indirect driver of future earnings, mediated by the long-term effects of Fed policy on the availability and price of credit, and relevant only once it eventually results in changes in economic growth rates. In reality, inflation is the most direct component of the price we are willing to pay for future earnings.

Consider a company with $5.00 per share of future earnings. Assume the earnings grow by 5% per year. Within ten years, the EPS will be $8.14. (In the long run, growth in earnings that handily outpaces growth in GDP is nice work if you can get it, but that is a subject for another post.) In an environment of low inflation and corresponding low intermediate-term interest rates, prospective earnings a decade away can have substantial current value.

But what if inflation were 10% a year? In that case, those future earnings would be worth much, much less. Higher inflation makes future cash flows less valuable for two reasons–first, because the future dollars we’ll receive will be worth much less when we get them, and second because a high-inflation environment is more essentially uncertain and unstable. If I lack confidence in the magnitude of future benefits, I will give greater weight to current availability. I’ll have my dessert right now, thank you, rather than wait for something better tomorrow evening.

Corporate earnings, measured by the S&P 500, have grown from $13.30 in 1979, when I started work as a stockbroker, to over $105 today. That is an increase of just over 8:1. But the price of the S&P? That has gone up by more than 25:1. The price we are willing to pay for each $1.00 of earnings has tripled over almost forty years. That rising tide has lifted almost all boats, so much so that the inflation-adjusted trailing price/earnings ratio we pay for the median stock in the S&P 500 was recently the highest ever.

Over the decades since the cyclical market low of August 19, 1982, the principal driver of rising stock prices has been falling inflation. For 90% of my career, starting in 1981, the inflation rate has either been declining or low and static. Most people working in the financial sector have never worked during a rising inflation environment. Quite a few have never actually experienced a bear market.

If inflation picks up, we won’t need to wait for a delayed and indirect effect on GDP growth and corporate earnings some years in the future. The effects will be felt much more quickly, as markets rediscover the pain of a less valuable future, manifested in the form of a lower structural P/E ratio.

What should we do about all of this? Two things. First, operate from a more-informed understanding of the true potential risks, which are about much more than hypothetical economic growth years from today. Our stock and bond portfolios contemplate higher inflation, along with other risks. Second, diversify internationally. Higher inflation in the US does not necessarily imply higher inflation worldwide.