"The issue is no longer whether the current market resembles those preceding the 1929, 1969-70, 1973-74, and 1987 crashes. The issue is only - are conditions like October of 1929, or more like April? Like October of 1987, or more like July? If the latter, then over the short-term, arrogant imprudence will continue to be mistaken for enlightened genius, while studied restraint will be mistaken for stubborn foolishness. We can't rule out further short-term gains, but those gains will turn bitter... Let's not be shy: regardless of short-term action, we ultimately expect the S&P 500 to fall by more than half, and the Nasdaq by two-thirds. Don't scoff without reviewing history first."
- John P. Hussman, Ph.D., Hussman Econometrics, February 9, 2000
"On Wall Street, urgent stupidity has one terminal symptom, and it is the belief that money is free. Investors have turned the market into a carnival, where everybody 'knows' that the new rides are the good rides, and the old rides just don't work. Where the carnival barkers seem to hand out free money just for showing up. Unfortunately, this business is not that kind - it has always been true that in every pyramid, in every easy-money sure-thing, the first ones to get out are the only ones to get out... Over time, price/revenue ratios come back in line. Currently, that would require an 83% plunge in tech stocks (recall the 1969-70 tech massacre). The plunge may be muted to about 65% given several years of revenue growth. If you understand values and market history, you know we're not joking."
- John P. Hussman, Ph.D., Hussman Econometrics, March 7, 2000
On Wednesday, the consensus of the most reliable equity market valuation measures we identify (those most tightly correlated with actual subsequent S&P 500 total returns in market cycles across history) advanced within 5% of the extreme registered in March 2000. Recall that following that peak, the S&P 500 did indeed lose half of its value, the Nasdaq Composite lost 80% of its value, and the tech-heavy Nasdaq 100 Index lost an oddly precise 83% of its value. With historically reliable valuation measures beyond those of 1929 and lesser peaks, capitalization-weighted measures are essentially tied with the most offensive levels in history. Meanwhile, the valuation of the median component of the S&P 500 is already far beyond the median valuations observed at the peaks of 2000, 2007 and prior market cycles, while our estimate for 10-12 year returns on a conventional 60/30/10 mix of stocks, bonds, and T-bills fell to a record low last week, making this the most broadly overvalued moment in market history.
There is a quick, knee-jerk response floating around these days, which asserts that “stocks are still cheap relative to interest rates.” This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis. It’s even an argument we recently heard, almost inexplicably, from one investor we’ve regularly agreed with at market extremes over several decades (more on that below). In 2007, as the market was peaking just before the global financial crisis, precisely the same misguided assertions prompted me to write Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios. See also How Much Do Interest Rates Affect the Fair Value of Stocks? from May of that year. Let’s address this argument once again, in additional detail.
Valuations and interest rates
There’s no question that interest rates are relevant to the fair valuation of stocks. After all, a security is nothing but a claim to some future stream of cash flows that will be delivered into the hands of investors over time. The higher the price an investor pays for a given stream of future cash flows, the lower the long-term return the investor can expect to earn as those cash flows are received. Conversely, the lower the long-term return an investor can tolerate, the higher the price they will agree to pay for that stream of future cash flows. If interest rates are low, it’s not unreasonable to expect that investors would accept a lower expected future return on stocks. If rates are high, it’s not unreasonable to expect that investors would demand a higher expected future return on stocks.
The problem is that investors often misinterpret the form of this relationship, and become confused about when interest rate information is needed and when it is not. Specifically, given a set of expected future cash flows and the current price of the security, one does not need any information about interest rates at all to estimate the long-term return on that security. The price of the security and the cash flows are sufficient statistics to calculate that expected return. For example, if a security that promises to deliver a $100 cash flow in 10 years is priced at $82 today, we immediately know that the expected 10-year return is (100/82)^(1/10)-1 = 2%. Having estimated that 2% return, we can now compare it with competing returns on bonds, to judge whether we think it’s adequate, but no knowledge of interest rates is required to “adjust” the arithmetic.
There are three objects of interest here: the current price, the future stream of expected cash flows, and the long-term rate of return that converts one to the other. Given any two of these, one can estimate the third. For example, given a set of expected future cash flows and some “justified” return of the investor’s choosing, one can use those two pieces of information to calculate the price that will deliver that desired expected return. If I want a $100 future payment to give me a 5% future return over 10 years, I should be willing to pay no more than $100/(1.05)^10 = $61.39.
So when you want to convert a set of expected cash flows into an acceptable price today, interest rates may very well affect the “justified” rate of return you choose. But if you already know the current price, and the expected cash flows, you don’t need any information about prevailing interest rates in order to estimate the expected rate of return. One does not have to “factor in” the level of interest rates when observable valuations are used to estimate prospective long-term market returns, because interest rates are irrelevant to that calculation. The only thing that interest rates do at that point is to allow a comparison of the expected return that’s already baked in the cake with alternative returns available in the bond market.