Could This Time Be Different?
I finally got around to reading a report from Scotia Economics that came out last month and compared stock pricing metrics for the S&P 500 to their historical averages. Like many others, the authors have concluded that stocks are cheaper than they have been over the last 20 years, but a 50-100 year history would put them around average value. So do we believe in reasonable growth in the future consistent with long-term valuations or a quick return to higher valuations?
There are three main factors that could have led to higher valuations over the past 20 years and may continue to do so in the future. Regulation is a big one that many individual investors may not take into account. While we never know the exact impact, the deregulation starting in the 80s could have fueled increasing corporate growth as well as more leverage (which raises values). The growing size of financial businesses contributed to the growth in the stock market as well as they went public. While this overall trend still has some momentum, we may be shifting towards more regulations in the future. Any change would take years to have an effect but this may lower future valuations.
Demographics are another popular theme. While there are many good arguments on every side, the last 20 years may have been the best time for baby boomers to invest, and they may start to gradually reverse that soon. On the other hand more open markets (due to less regulations) allow global investors to buy up assets. A few people retire expecting to live 5 years and leave no inheritance so many people may stick with an allocation that lets them plan for a longer time period.
Investor psychology is the third component. Following the financial cowboys of the 80s and the tech speculation of the 90s we may be seeing an increased focus on the stock market from ordinary investors which could last much longer and keep prices higher. As the Scotiabank report says, “40 years olds in the 1980s held far less debt in
inflation adjusted terms and had far lower equity ownership rates than 40 year olds in the lead up to the crisis”.
There was a time when stock dividend yields were normally above bond yields. In the 60s they crossed over and anyone who was waiting for a “return to normal” would be holding their breath for 40-50 years. It may be that investors back then decided the long-term returns of a stock including growing dividends and price appreciation were worth more than a bond with a similar annual cash yield. And maybe investors perspectives have changed again to focus more on price appreciation, although this is self-defeating and true long-term investors can’t buy into it fully.
So was the last 20 years just a time when there was more demand for assets than actual assets, driving up the prices temporarily? Or have fundamental factors changed in a way that will last for another 40 years? There are no good measures. The closest ones typically move at the same time as equity prices. Just like the prices they tell us little about the future since they are high until they aren’t. In a way this doesn’t matter much. I believe in stock market investments and I fear overvaluation, so as long as we stay near or below reasonable prices I’m happy to invest more. But this does show that it’s not quite time to borrow everything you can and put it into stocks. A balanced approach will minimize the future risks.