Is the stock market cheap or expensive?

A recent magazine cover highlights the current mood in stock markets. The collapse in March seems like a distant memory given that most stock market benchmarks around the world have surpassed their previous highs or are fast approaching them.

Stock valuations collapsed at the height of the COVID crisis in March but have since surged to levels not seen since the Dot-com boom. Both the ASX100 and the S&P500 valuation multiples have roughly tracked each other over time and are currently looking stretched on an absolute basis. Specifically, the PE multiple of the US market is approaching its 1999 high. The Australian market looks more overvalued given that its PE multiple has exceeded its Dot-com boom peak.

Source: Refinitiv for SP500 and UBS for ASX100

The bears argue that equities are expensive because absolute valuations are extremely high and must mean revert. The bears have been holding their breath for a very long time and the COVID crisis fleetingly proved their point in March 2020. However, since then they have been left behind by one of the fastest stock market recoveries in history.

Do low interest rates lead to higher valuations?

The bulls argue that stock valuations are high because interest rates are low. To a certain extent, lower interest rates lead to higher valuations as it is a key input in discounted cash-flow valuations. This relationship has been clear since the Global Financial Crisis (GFC) in 2008, when rising valuations have coincided with falling interest rates. However, over the long term the inverse relationship between rates and equity valuations is not obvious. To illustrate this, the chart below shows the Shiller Cyclical Adjusted PE ratio (a variation of the PE ratio using 10-year average earnings adjusted for inflation) against long term interest rates spanning over a century. 

Source: Vertium, http://www.econ.yale.edu/~shiller/data.htm

There have been two periods when interest rates experienced secular declines (1921 to 1941; 1981 to present day). During those periods there is no clear linear relationship between falling rates and rising valuations and vice versa. There were periods when equities were out of favour while interest rates were falling. For example, in the period 2006 to 2008, interest rates halved but the Cyclically adjusted PE ratio fell from 25 to 15. On the other hand, there has been long periods (for example, 1941 to 1966) when interest rates doubled but equity valuations rose significantly. Empirically, the interest rate argument alone is insufficient to explain extreme valuation movements.

Does a wide equity risk premium lead to high valuations?

The bulls also argue that equities must rise because sentiment is too bearish relative to low interest rates – that is, there is no alternative. Specifically, the equity risk premium (the premium required by investors above the risk-free rate because of risky equity cashflows) is too conservative.

The equity risk premium is often proxied by the spread between the market’s earnings yield (inverse of its PE) and interest rates. The table below highlights that the current risk premium for both the Australian and US market as at the end of December 2020.

Source: Vertium, UBS, Refinitiv

Based on this measure, the Australian market looks cheaper relative to interest rates than the US market given that its earnings yield spread is higher at 4.3%. The yield spread also changes over time and is dependent on market sentiment and interest rates. The current earnings yield spread of around 4% looks relatively wide versus its long-term history.

Source: Refinitiv for SP500 and UBS for ASX100, Vertium

The bulls argue that today’s valuation is nowhere near overvalued compared to the Dot-com bubble when the earnings yield spread was -2.4%. However, if we extend this logic further and assume that the current earnings yield spread was to mean revert to 0%, which was the average spread during the 80s and 90s, it implies that the stock market’s PE multiple should be 100x, assuming interest rates remain at 1%. That is, the market should be valued at 5x greater than today.

The stock market trading on 100x PE multiple may seem farfetched, but perhaps the earnings yield spread is bounded by an upper (cheap valuation) and lower (expensive valuation) boundary based on the economic conditions at the time. For example, in the 1980s and 90s economic growth was much stronger, which led to lower risk premiums as the average yield spread was closer to 0%. The upper boundary was at 1.5% when the market was cheap, and the lower boundary was at -1.5% when the market was expensive. During this period, it is easy to spot (in hindsight) the 1987 and 1999 Dot-com bubbles.

Source: Vertium, UBS, Refinitiv

In the post 2007 period, economic growth was much weaker, which led to a higher risk premium with the average earnings yield spread of 4.3%. During this period, the upper boundary for the US market is around 5.8% and the lower boundary is around 2.8%. Again, it is easy to spot (in hindsight) market extremes such as the 2008 GFC, 2011 Euro Crisis, and 2020 COVID Crisis.

The current US earnings yield spread is trading at 3.6%, which indicates that the market is slightly more expensive relative to interest rates than the post 2007 average of 4.3%. It also indicates that the stock market is not in bubble territory compared to recent history.

However, there is an important point to consider when interest rates are used as inputs into any measurement - the economy is not static. While interest rates may remain structurally low, they do not remain constant and are still cyclical. Interest rates rise and fall with the economic cycle. Currently, interest rates have risen off their lows as the global economy is recovering from the COVID crisis.

The Australian 10-year bond yield has already mean-reverted to pre-COVID levels in January 2020, but US long term interest rates have lagged. If US 10-year bond yields rise by another 70 basis points from its current 0.9% to 1.6% (January 2020 levels) it would contract the yield spread from what is considered relatively healthy at 3.6% to the dangerous valuation boundary at sub 3% in the post-2007 world. In other words, it would not take much for rates to rise, squeeze the market’s optimism and make the yield spread very expensive.

Speculation is high

While we may postulate whether the market is expensive or cheap based on interest rates or the equity risk premium, speculative activity remains high. There are several markers highlighting that investor sentiment has approached exuberant levels, last experienced during the Dot-com boom.

1. Excitement of stocks added to the index

Tesla has been one of the hottest stocks on the planet. It surged 480% in the 12 months leading up to the announcement of its addition to the S&P500 Index. In the six weeks between the announcement (16 November 2020) and its index inclusion (21 December 2020), its share price rallied more than 60%. Tesla’s increase in enterprise value of about US$230 billion since the index announcement is astounding because it is equivalent to the entire value of the third largest auto manufacturer in the world, Daimler. Tesla’s inflated total enterprise value is now roughly the same as the combined value of the three largest auto manufacturers in the world (Volkswagen, Toyota, and Daimler). This is despite the three largest auto manufacturers together produce about 23 million vehicles annually compared to Tesla expecting to produce 1.2 million cars in FY23.

Tesla’s index inclusion is reminiscent of when Yahoo was added to the S&P500 during the Dot-com boom. Yahoo was the most popular search engine in the world in the late 1990s and was one of the hottest stocks at that time. It rallied 122% in the 12 months leading up to its S&P500 inclusion. In five trading days from announcement date (30 November 1999) to index inclusion (7 December 1999), Yahoo rallied another 63%. Yahoo’s share price continued to increase by another 36% to reach its all-time high in January 2000. Sometimes momentum begets momentum.

Source: FactSet, Vertium

2. Excitement in public listings with minimal or no revenue

The spectacular rise in Tesla’s valuation has encouraged several unproven electric vehicle companies to seek public listings. Many of these new start-ups are promising large future profits, despite Tesla taking close to decade to become profitable. The only other period when there has been a flurry of unproven businesses raising large amounts of capital from the public was during the Dot-Com boom.

3. Hot IPO market

One of the best performing Australian IPOs in 2020 was NUIX, a technology company, which delivered a 51% return on its first day of trading. However, Australia’s IPO market has not been as spectacular as the US market. US IPOs such as Snowflake, Airbnb and DoorDash have delivered far greater first day returns of 112%, 113% and 99% respectively. These performances are not isolated examples as the average first day return from initial public offerings in 2020 was about 50%. The current IPO excitement is on par with the Dot Com boom.

Source: Jay Ritter, https://site.warrington.ufl.edu/ritter/files/IPOs2020Statistics.pdf, Vertium

4. Valuations of unprofitable companies

Buying unprofitable companies may be considered speculation to many investors. While there may be some legitimate businesses that purposely depress short-term profits (for example, Amazon) there are others that simply have weak business models. However, as a group they generally trade together. Who does not want to find the next Amazon?

Measuring changes in the aggregate market capitalisation of unprofitable companies provides another proxy for investor sentiment. Currently, US technology companies with negative earnings are approaching the value of US$1 trillion. At the height of the Dot-com boom, these types of companies reached an apex of US$700 billion market capitalisation.

Conclusion

The COVID-19 crisis continues to impact our everyday lives. From lockdowns to border closures, uncertainty abounds. When will many people around the world return to work? When will we be able to travel overseas again? How long the crisis will last?

As far as the stock market is concerned, it is as though the COVID crisis never happened and the market is currently eyeing past the COVID crisis. Sentiment in the stock market is high. Several markers such as the excitement of hot stocks added to the index, public listings of companies with minimal revenue, the hot IPO market, and high valuations of unprofitable companies highlight the exuberant mood.

From a valuation standpoint, valuation multiples are stretched on an absolute basis. However, a big argument to buy stocks on high valuations is their relative value to extraordinarily low bond yields. On such metrics, the market’s valuation seems reasonable. Compared to the US, the Australian market is exhibiting a greater margin of safety given its wider earnings yield spread.

However, we should not lull ourselves into a false sense of security. It is important to note that Australian market movements are still correlated with the US market. With an economic recovery underway, the prospect of rising interest rates is increasing. With the earnings yield spread of the US market already below the post GFC average, it would not take much for rates to rise and make the US stock market expensive relative to interest rates.

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