“Are high stock prices reasonable in a low growth economy?”  

To answer this question, I decided to setup a simple valuation metric starting in a state when prices were seen as fairly valued using the dividend discount model (DDM) to find the fair value (FV), where D1 [D0*(1+g)] is the expected dividend, k is the discount rate (yield on 10-yr TBond), and g is the constant growth rate.

[In geek speak, observations are single-period, steady states where variables are in equilibrium, especially the risk premium (k-g). I want to point out that D1 makes no sense and reasonableness is probably due to offsetting errors in risk premium (k-g).]

To get started, I used the 1980 period after Volcker raised the Fed funds rate to 20%, TBonds were at 16%, and grow was 8% approx. I then plugged in a D1 that would give me a FV of 1000 on the DJIA. Not knowing what to expect, I created several states as both interest rates and growth fell by 50%. As shown below, each lower growth state produced a value multiplier of 100%.

ex1

Next, I asked myself “Is this reasonable?”

The second row roughly equals the 1980s value metric where DJIA fair value would be 2160. Steady state variables may vary over time, especially in overvaluation that sees lower risk premiums and higher g, but usually results in a “snap-back” as variables return to the steady state. For instance in the first half of 1987 the DJIA reached 2750, then snapped back to 1800 in the Oct crash.

The third row represents the 1990s, where risk premiums became very small as growth soared. However, starting in 2000 with the dot-com crash the DJIA went from 12000 to 7000 never reaching fair value although the SPX went down 50% and the Techs 80%.

The fourth row is roughly where we are today with the 10-yr TBond at 2% and steady state growth at 1%. FV for the DJIA is 9165 which compared to 18000 means the stock market is 100% overvalued. For those of you who read John Hussman, you know that this is exactly what he has been saying for the past two months and his models are much more complicated.

So, yes the results are reasonable.

The sixth row is the Japanese scenario where long term growth continues to spiral downward. I see this as unlikely at present.

My most likely scenario. The recent rise in the dollar and collapse of the Euro has certainly clarified what I see as “no way out”. It is likely that the US economy will enter row five the first half of next year as the economy slows down and 10-yr rates approach 1%. However, by the second half of next year the collapse in the Euro should turnaround the EU economy, possibly sharply. As to US stocks, low growth will push valuations up to DJIA 18514. I expect the price levels to increase by the change in valuation or to about 27000 by the end of next year. A small “snap back” may be seen in the traditional May-Oct selloff period in 2015.

The following two years should see a steady improvement in economic growth worldwide and a decline in the US dollar as the global economy moves into row three, the 2% inflation range where 10-year rates return to 4% and growth is 2%.

Here is where we find the monster in the closet. As interest rates rise, bond portfolios represented by the 20-year TLT will lose 40%. Retail investors who have fled the stock market into bonds because of the weak economy will find that stocks have gotten away from them and as bond losses continue to mount are likely to panic out of bonds and back into stocks, driving interest rates even higher. Stock prices will continue to rise even as fair value falls due to higher interest rates. The DJIA rises to 36000 or beyond as fair value approaches 4500. A panic out of bonds could compress this to one year.

Now we get a snap-back or dislocation similar to 1929 that continues for about three years as the stock market gets back to fair value.

In conclusion, financial repression may force investors to pay higher and higher prices for low returns, but there is no way out.

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