Many say that lower interest rates should raise asset valuations by lowering the rate at which future income streams are discounted. This may be fine for high quality government bonds where coupons are fixed, but is not necessarily the case for equities where we are dependent on future flows (earnings, dividends, economic growth, CAPEX).
What is the major determinant of long term real equity returns? Earnings growth, and long term earnings growth is dependent on real economic growth. If we look at real growth rates they are falling, and have been falling for some time. This is part of the reason why interest rates have been falling; that is to accommodate falls in nominal and ultimately real flows.
The following shows annualised annual growth rates over rolling 15 year time frames (in other words geometric returns) compared to the Shiller Cyclically Adjusted PE ratio:
At the same time as real growth rates are falling, valuations are rising. There are a number of reasons for this: low interest rates and associated increases in broad money supply growth over and above nominal GDP has increased the asset focus of money supply. Since 2009 aggressive global quantitative easing has further pressurised the search for yield.
Share buybacks, in the US in particular, have also contributed by reducing the supply of stock and by increasing the supply of asset focussed money.
But while earnings growth at the economic level has been rising, it has in fact diverged considerably from economic growth, largely due to rising profit margins. Note the following chart showing profit growth from the BEA accounts using a measure that corresponds to an S&P 500 earnings profile:
And then we look at growth relative to nominal GDP growth:
If we look at annualised growth over 15 year rolling time frames we find that profits growth relative to GDP growth is at post 1929 highs, and quite possibly at all time highs.
One of the main issues obscuring earnings growth trends and in particular those that should be reflected in valuation models is the fact that earnings growth has been relatively stable historically:
We get a different profile when we look at profits to GDP ratios:
Looking at corporate profits profiles most similar to that of the S&P 500 we see, excluding the war and early post war period, profits as a % of GDP are at historical highs, and the difference is most striking on an after tax basis. I would be nervous about using WWII and post war profit percentages as relative benchmarks for obvious reasons, one of which I note graphically below.
Looking at the figures with IVA and CCAdj we can also see a profit peak in the mid 1960s that is worth noting with respect to the sustainability of current peak profit margins.
The mid 1960s saw a notable peak in economic activity followed by a fall off in asset price performance, so we need to be very careful when assessing historical benchmarks:
One other point extremely important point is that the peak to peak change in profits growth has also slowed considerably and is another factor when determining just how solid current earnings growth margins and relationships really are:
Peak to peak this is the weakest showing of the current profit super cycle whether we use IVA and CCAdjustments or not.
And we must bear in mind the real weakness in the economic frame. The annual change in real personal consumption expenditures, shown on a per capita basis below, have declined since the late 1990s and from a higher GDP base are no stronger than they were in the 1980s.
I believe that we have been carried away with the high asset valuations and the considerable asset price support since the late 1990s in setting our current capital market risk and return expectations.
Things appear to be getting more volatile, but the direction of change is not upwards whether you look at in nominal or real terms:
So just because interest rates are low does not necessarily mean that asset prices should be likewise higher. In fact, in most valuation models both the discount factor and the cash flows have very similar determinants, so be warned. Yes, of course, monetary policy has lowered yields and interest rates to levels that would support asset prices, but I doubt very much whether this should extend to current valuation levels given the risks we face.
We are not in a general equilibrium environment, and I believe that we are also likely not even in an out of equilibrium moment but in an unstable accommodated equilibrium point. In this the discount factor needs to shift from what an equilibrium assessment would suggest and shift to a more risk aware required rate of return.