Figuring out the fair value of a stock is an inexact science and at least one expert concludes that it would take six decades for stocks to reach that point if real interest rates remain where they are now.
Market strategists, portfolio managers and ordinary investors traditionally decide equity asset allocations by looking at the expected relative return of stocks over cash and bonds. But in order to do that they need to have a view about future interest rates, adjusted for inflation, especially the risk-free cash rate, and that is almost impossible to do, according to James Montier, a member of the asset allocation team at GMO, the global investment management firm.
“No one truly knows what the future real rate will be [and] it would be dangerous to build an approach to asset priced based on something very uncertain,” Montier writes in his latest white paper, The Idolatry of Interest Rates Part II: Financial Heresy. “Yet an approach that puts the real cash rate at its very heart is surprisingly common.”
Some researchers like Shane Shepherd of Research Affiliates, whom Montier quotes, gauge stock and bond returns against the equilibrium real rate of interest, which former Fed Chairman Ben Bernanke defines as the real interest rate consistent with full employment of labor and capital resources. “This is the intellectual equivalent of building on quicksand,” writes Montier. (Needless to say Montier is not a fan of the ERIR, see ThinkAdvisor’s story on his first installment of The Idolatry of Interest Rates GMO: Monetary Policy Is ‘The Greatest Con Ever Perpetuated’).
Others focus on the expected excess return of stocks over the risk free cash rate, known as the equity risk premia (ERP). “This is … akin to taking a glass of water (the likely return on equities) and adding some mud (the interest rate) and then finding one’s self with a glass of muddy water,” says Montier.
The problem is not that cash rates don’t matter when valuing equities, it’s that “we can’t really tell what the real rate will be in a range that matters for our investments,” says Montier.
That’s because, says Montier, the ranges for expected interest rates and equity risk premia vary greatly. He cites several research papers to that effect, with ERP estimates ranging from roughly 1.5% to 8% and real cash rates ranging between 0.4% and 2.1%. Together they would yield widely varying expectations and analyses.
Montier, who’s a member of GMO’s asset allocation committee, then digs even deeper. He compares a model using the ERP approach with one using the Shiller P/E model, which is a cyclically adjusted price-to-earning model for the S&P 500, and he tests these forecasting approaches against what actually happened. The Shiller P/E model has fewer errors. Then he decomposes the forecast error of the Shiller P/E model into its contributions from fundamentals, P/E and margin.
“There have been times when the real interest rate was negative and the model overpredicted reality—the complete opposite of the ERP approach claim,” he said. “Similarly there have been periods of relatively high real interest rates when the model underpredicted reality. There simply doesn’t appear to be any consistent pattern.”
Montier concludes, “Even if you believe that real interest rates do matter for equity market valuations, and hence that lower real rates justify higher sustainable levels of P/E you still need to ask yourself the following question: Would I need to believe that today’s U.S. equity market valuations represent fair value?” If you do, Montier poses another question: “How long would you need to see real interest rates stay at -2% p.a. (per annum) in order to be able to call today’s cyclically adjusted P/E fair value?” His answer: 60 years. (Real interest rates currently are actually higher than -2% because inflation is running between 1.3% and 1.8%, depending on which measure is used.)
Ben Inker, co-head of GMO’s firm’s asset allocation team, agrees with Montier’s critique that stocks are overvalued today—GMO is “staking out a position that both stocks and bonds are overvalued,” writes Inker—and that the ERP framework is flawed, but he says it’s dangerous for investors “ignore the low yield on cash.”
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