I call it: “Cheap US equities: the low-rate adjustment.”
The strong post-March 2020 rebound in US equity prices rekindled rumblings about stretched or even “bubble-like” valuations. Myriad metrics can be rolled out to suggest “excessive” price levels, but how often do these arguments account for the broader investing landscape — inclusive of interest-rate expectations and the relative risk/return offered by US Treasuries? I believe they should.
Acceptance of paradigm shifts
One way to think about the relative value and appeal of equities is to look through a fixed income lens with a focus on risk-free rates. For the past decade, US stocks have remained cheap relative to Treasuries because (in my view) many investors have been unwilling to accept the idea that interest rates would stay low — similar to how bond investors in the 1990s were slow to adapt to a new (lower) inflation regime.
As the now “lower for longer” yield paradigm becomes more entrenched as a base case, investors may have to incorporate persistently lower risk-free discount-rate assumptions into valuation models. I believe the recent “leg lower” in interest rates has accelerated the need to confront this issue. One reason equity-risk premiums are elevated is because investors have yet to fully adjust to the ultralow-rate setting. Until they do, I think there is room for equity valuations to keep expanding.
Current equity vs bond compensation
Given today’s lofty equity-risk premiums, I believe investors are still getting compensated for inflation risk in equities, but not in bonds — quite unlike the environment of the 1990s. As time passes, there could well be a move toward creating an equilibrium, whereby either bond yields sell off or equities rally to reflect lower risk-free rates. I believe the latter scenario is the more likely of the two.
Looking at it another way, Figure 1 plots real yields, calculated by subtracting the CPI from the free-cash-flow yield on the S&P 500 Index (light blue line) and from the nominal 10-year US Treasury yield (dark blue line). The real yield on the S&P 500 post-2008 has remained stubbornly high, both relative to bonds and to its own pre-2008 history (dating back to 1990). Going forward, I believe investors’ prospects for “real” returns are better in equities than in bonds.
Despite the attractiveness of stocks vis-à-vis bonds, traditional portfolio management theory and the barriers faced by institutional investors are likely to continue to hamper widespread acceptance of this paradigm shift, thereby preventing relative equity valuations from reaching what I’d call “fair” equilibrium.
Just as bond investors weren’t prepared for inflation to trend meaningfully lower in the 1990s, today’s investors may look back years from now on an extended period of undervalued equities, rooted in underestimating the staying power of low interest rates.
- Beware the perceived “safety” of bonds, particularly longer-dated US Treasuries.
- In the context of real returns, equities appear cheap relative to bonds — especially if you believe (as I do) we’re in an enduring low-rate environment.
- Current equity valuations provide a historically large cushion for investors to absorb higher inflation expectations or a rise in nominal Treasury yields.
- With the right dose of inflation, and if COVID-19 vaccines help the economy revert to “normal,” it’s entirely possible that US stocks may still do quite well.
- Despite sitting near all-time highs, perhaps we should be more “worried” about a right-tail-risk event (a big upswing) in equities than a left-tail-risk event (a sharp correction).