Is the Market Overvalued?

We are in a very unusual time in my opinion. Presently valuations are high--whether you look at P/E (or the inverse, earnings yield), P/Sales, stock market valuation to GDP, Q ratio, or whatever else you want to use--but many argue it is not a bubble.

Generally, the majority can make seemingly plausible arguments for high valuations during the bubble (otherwise you wouldn't end up in a bubble in the first place) so the fact that consensus says there is no bubble doesn't mean much. However, what is different right now, is that the contrarians and those that believe we are in a bubble, can't seem to make a strong case. I think the reason is due to there being no psychological or behavioural elements that are driving the bubble--the mania is missing.

I think what is happening is that the mania is not in stocks but in bonds. The bond market, which is larger than the stock market, has a big bubble. Investors are literally buying bonds without any regard for yield, with big chunks of capital being deployed at less than 2% yields (including some very close to negative yield). Long-term inflation in USA is around 3% so you are essentially look at a loss in real terms. Basically, the mania is in bonds.

The bond mania is impacting stocks hence it is not directly observable in the stock market. That's my view right now.

In any case, if you are a contrarian or macro-oriented, you might want to check out this piece by James Montier of GMO, "Six Impossible Things Before Breakfast" (Mar 2017) [main page link]. Montier is in the minority and doesn't share the general consensus (i.e. enthusiasm for stocks). He goes over 6 things he feels investors are assuming that are likely false. I don't necessarily agree with everything he says--is secular stagnation really due to policy?--but do share his overall stance. I'll just list the 6 items he addresses and leave it up to you to read the piece if you are interested.

In order to make sense of today’s pricing, you need to believe in six impossible (okay, I’ll admit some of them are just very improbable as opposed to impossible) things.

1. Secular stagnation is permanent and rates will stay low forever. As we have argued at length elsewhere, secular stagnation is a policy choice and we could exit it reasonably quickly by implementing appropriate policies.

2. The discount rate for equities depends on cash rates. This is nothing more than a belief. It has no foundation in data and not a scrap of evidence exists that supports this hypothesis.

3. Growth rates and discount rates are independent. This is a very questionable assumption. If, as I believe, it is false, then it makes the “Hell” outcome Ben has discussed in previous Quarterly Letters less likely, unless the first two beliefs hold completely.

4. Corporates carry out buybacks ad nauseum, raising EPS growth despite low economic growth. This would imply rising leverage, which is already close to all-time highs. Remember Minsky: Stability begets instability.

5. Corporate cash piles make the world a safer place. Cash levels aren’t high by historic standards, and valuations are extreme even when cash is fully accounted for.

6. The “Hell” scenario is the most probable outcome. This requires “this time is different” to be true and, unlike Jeremy Grantham, I am not yet ready to assign this exceptionally useful rule of thumb to the waste bin of history. Put another way, Hell requires that stock prices have reached a “permanently high plateau,” and I’m not about to embrace that statement.