mattee2264

Dow 40,000 as I recall is based on the idea that there is no need for an equity risk premium because you get your margin of safety from growth of earnings. On that basis if bonds yield around 3-4% over the next decade or so then PE multiples of 25-30x are reasonable. Of course the catch is that historically you got a higher earnings yield to compensate for the risk of investing in equities and essentially got the long term earnings growth for free. And therefore unless long term earnings growth is a lot faster than historically has been the case you aren't going to get 10%. And it is reasonable to say that in a low interest rate environment (i.e. lower risk free rate) where the perceived risk of investing in equities is a lot lower (because of the Fed put) and where the inflation protection equities offer seems particularly valuable, then you're being greedy insisting on 10% expected returns. Buffett has a great analogy about not wanting to be like a mortician waiting for a flu epidemic that is apt.

As Greg says 5% returns do not excite anyone. Especially when you consider how well equities have done over the last 5, 10, 15 years. Admittedly the equity risk premium is now in the negative territory and therefore investors are banking on future earnings growth for their margin of safety. But when confidence is high and there is the belief that the Fed will rescue markets at the first sign of trouble and AI will power fast earnings growth for technology stocks and eventually the rest of the market it isn't difficult to understand why there is still a strong preference for equities in spite of the fact there is now an alternative. Besides most investors are confident that interest rates will eventually fall and therefore are still using low discount rates.

Maths can be seductive because there are lots of assumptions you are making which can be questioned. Equities and fixed income: Bond yields have been manipulated for a long time. And with a lot of debt in the system financial repression is the least painful way out and with it some kind of yield curve control. Also you are implicitly assuming that short term interest rates are staying at 5.25%. The market doesn't believe they will and that is why they are using a lower discount rate. If the market is correct and we are at peak interest rates then it would be a mistake to base your valuation math off of this. And if you are using a discount rate of 10% you are assuming a risk free rate of about 5% and an equity risk premium of a similar amount. I've already discussed the risk free rate. But there are reasons why investors might be prepared to accept a lower equity risk premium e.g. prevalence of passive investing which through diversification eliminates stock specific risks, continued confidence in the Fed put and the ability and willingness of central banks and government to actively manage the economy, and the belief that the future growth of stocks rather than an earnings yield greater than the bond yield is enough to compensate for the greater risk of equities. I agree with you that earnings and margins have had a boost from low interest rates (still largely locked in due to 2020-2021 refinancings) and lower taxes so that is certainly a headwind for stocks but there are plenty of tailwinds as well such as AI and other technological breakthroughs, the beneficial impact of moderate but low inflation on nominal earnings growth, benefits of US immigration etc. Real estate Again depends on whether you think interest rates will stay at current levels. This is especially true because in the short term when houses are unaffordable people don't buy and people don't sell I am also a little suspicious of long term historical earnings multiples because most families these days are dual income and a lot of people have side gigs. And it could just be that in the past housing was cheap because it was more plentiful. Now in many areas it is in quite short supply which helps to explain high prices.

High valuations are rational in a low interest rate environment. They are also rational if the market is correctly anticipating rapid earnings growth. I suspect a combination of both factors are at play today. Everyone is expecting that the Fed will pivot in a meaningful way and interest rates will fall 200-300bps over the next few years. And if interest rates are 2-3% then a market PE of 25-30 doesn't seem unreasonable. And it is reasonable to pay a high price for current earnings if you think they will be a lot higher in the near future. And it isn't hard for tech optimists to contemplate a market with a very high tech concentration can do so, especially if the benefits of AI filter down to the rest of the index resulting in productivity improvements and much higher future earnings. Of course with the benefit of hindsight the market could end up being overvalued if we are in a higher for longer interest rate environment or if the expected benefits of AI do not pan out and big tech companies hit maturity and their earnings growth slows meaningfully. And it is also worth remembering that the market takes some time to realize things have changed. It took many years for the market to reward the likes of Microsoft, Meta, Google, Apple with premium valuations. And similarly it took markets a while to realize that ZIRP wouldn't be quickly reversed and to start pricing in the Fed put. So high valuations may persist for a while even if they may at some point no longer be justified. Of course it could be quicker if something does happen to shake the market's confidence. For example a meaningful 2nd wave of inflation which results in the Fed hiking rates and taking a much more aggressive stance which makes market's question whether the Fed pivot still exists. Or some kind of trigger event that undermines tech optimism or alternatively a wave of earnings disappointments. Or a recession which destroys historically high margins and tests faith in the idea that tech companies are immune to the cycle because their secular growth tailwinds are so strong. Then again it could be that the AI growth miracle is everything everyone hopes it will be and will deliver faster growth, lower inflation, lower interest rates, explosive growth for tech companies as far as the eye can see that trickles down to the rest of the market. And that will probably get things bubbling up. But markets will be way higher before anything bursts.

The challenge because of the way humans are wired is that for most people the only way to get rich is SLOWLY. That is why for most people buying a house and pension salary sacrifice schemes do the heavy lifting. A mortgage is a form of forced saving and the human desire to buy as big a house as they can possibly afford also means they end up "saving" a high percentage of their income in the form of mortgage payments. Pension salary sacrifice schemes aren't anywhere near as generous as final salary schemes (which were predicated on most people not living long after retirement!) and most people only do the minimum salary sacrifice but there are tax benefits, returns are juiced a bit by any employer match and as it is automatically deducted from your salary you cannot spend the funds. With the above in place even living pay check to pay check even on a middle income you can still hope for a comfortable retirement assuming long term returns on stocks aren't too far from the historical average and real estate prices keep up with inflation as they have done historically. Although without the tailwind of 40 years of falling interest rates which has only just started to reverse and the phasing out of final salary pension schemes there aren't going to be many people who will be retiring rich. Basic financial maths tells you that all things being equal long term equity returns are going to be lower from high starting valuations than from low starting valuations and real returns are likely to be more disappointing because stock markets are still pricing in a low inflation environment (just as in the early 80s they were still pricing in a high inflation environment). So rather than 6-7% real returns you'd probably get half that. And while historically you could usually get about 2% real on long bonds for that to be the case today you have to be confident that the Fed can get inflation back down to target and keep it there which seems highly unlikely when there are very strong political incentives to engineer financial repression to help ease the government debt burden and continue to encourage people to take equity risk. Lower expected returns from a typical 60/40 portfolio can be offset by taking more equity risk and 80/20 is gaining popularity. And a lot of retail investors are using leveraged S&P 500 ETFs and made money buying call options on popular tech stocks. But it is called equity risk for a reason and eventually those risks will materialize and most people overestimate their risk tolerance and risk capability especially during a period where returns have been generous and downturns have never lasted more than a year and been quickly reversed. Lower expected returns can also be offset by saving more. Most people even in today's climate can still find a way to save 10% of their income just by avoiding impulse buys, budgeting sensibly and so on. But with housing now unaffordable in most of the country and prices of most things 30-50% higher than pre-pandemic (while wages increases after the tax cut are a fraction of that) to save much more than that does require a good dose of frugality which doesn't come naturally to today's generation. Most people saved a lot during the pandemic because they couldn't travel, couldn't go to restaurants or bars etc. and no-one else could which meant you were forced to socialize in the park or at each other's homes. But those times were pretty miserable for most. As for the idea that sex is free. That may be true when you are young when there is a hook up culture and girls care more about your looks and popularity than your bank account. But for most men dating is expensive especially in big cities and the more attractive the woman the more high maintenance she is likely to be.

Eldad: might be a reverse correlation. Generally if a man is a good provider type he is more likely to get married and stay married and the same financial stability and sense of responsibility that attracted his wife is going to contribute to his continued financial success in life.

Oh and another thing. Everyone knows that massive amounts of excess savings were built up over the pandemic. In part this was because of stimmy checks and a stock market where retail traders made hay. But another factor was that if you can't travel, if you can't eat out, if you can't party and go to bars, if you spend all your time at home watching Netflix, and none of your peers can do so either then of course you are going to wind up saving a huge amount of money.

Reminds me of the book "Millionaire Next Door". To actually accumulate a lot of wealth you need to live at least a socioeconomic level or two below your means. That is difficult especially when in this day and age even a middle class lifestyle is very expensive with the spiralling cost of housing, childcare, groceries etc. And even if you are prepared to make those sacrifices your wife and children might not. And the alternative of chasing money by working in well paid jobs with long hours and high stress may allow you to maintain a high standard of living while still managing to save a lot of money (not least because you do not have time to spend it!) but that has its downsides such as not seeing much of your friends and families and slaving away in a job you don't enjoy because let's face it not everyone tap dances to work like Buffett does! And there is the risk of going to the other extreme. You read a bit about the FIRE crowd who are trying to save half their pay checks in the hope of retiring early. But it doesn't sound like much of a life. And even if it works out who's to say you don't drop dead at 50 from a heart attack or suffer ill health in old age so you end up housebound and unable to enjoy your life much. And when you are old you may end up regretting not spending more time in your youth boozing, chasing girls, going on adventure holidays etc. Whereas if you had a lot of fun in your younger years it may be easier to slow down in your old age and enjoy a much simpler and less expensive lifestyle.

Copper recently took out the 2022 high and hit over $5 per lb. And sits at double the 2016 and COVID lows. Copper producing companies are on a roll as well and as you'd expect they've seen stock price appreciation even better with Southern Copper and Antofagasta up 3x from those lows and Freeport up 5x. Usually I would just assume it was a cyclical trap and usually the best time to buy commodities is when commodity companies are making losses, commodity prices have slumped and sentiment is negative. But there seem to be good reasons to expect another super cycle and if that is the case we are probably still in the early innings and there is a lot more gains to come. Copper seems as though it will be the new oil. Needed for all of the clean energies, needed for AI data centres, needed for electric vehicles, and also for the military as geopolitical tensions ramp up globally. And there do not seem to be any good substitutes. So demand seems set to grow rapidly in coming decades. Meanwhile supply is scarce. There has been underinvestment for many years. And unlike iron ore which is relatively abundant, there isn't that much copper in the world. And it isn't easy to bring new supply online so there could be structural shortages for quite some time. And it also does very well in inflationary environments so you get an inflation hedge to boot if you are worried of monetarization of the insane amounts of government debt. Any thoughts?

Post-pandemic I can definitely understand the issue. Official government statistics claim that the price level has risen about 20-30% since the pandemic. But in the real world it is probably more like 50% especially for items such as groceries, entertainment, restaurants, travel etc. and salaries haven't even kept up with official inflation rates. You are seeing the cost of some items such as groceries come down. But a lot of companies have been able to get away with jacking up prices using the pandemic supply chain disruptions as an excuse and when these disruptions eased and their costs came down didn't pass on the lower costs to consumers. And got away with it because consumers had excess savings from the pandemic, unemployment is low, in many cases mortgage payments are low as people refinanced during the pandemic, and consumers have credit cards that allow them to live beyond their means at least in the short term. You also have some criminal buy now pay later schemes (phantom debt) to trap consumers. Wouldn't be the worst thing in the world if we did have a recession, a lot of credit card defaults, and companies were forced to lower prices (and margins are still close to record highs) so they can easily afford to do so.

Seems pretty plausible. Of course it is not as bad as it sounds because if you are paying down a mortgage and contributing to a company pension plan you will still be able to eventually retire in relative comfort. And that will be the position of a lot of middle class and some upwardly mobile working class households.

Easy....the economy will weaken and already some signs of that....real GDP growth 1.6% in Q1, retail sales flat in nominal terms MoM (and negative in real terms), labour market worsening with companies slashing jobs left right and centre, and markets will shoot to the moon because all that matters to them is that the Fed will deliver on rate cuts.

There is your argument right there. USA has a CAPE of 34x and China has a CAPE of 10x. In China you are getting about a 700bps equity risk premium. In USA you aren't getting any kind of equity risk premium (expect implicitly through future growth prospects). Of course China is a basket case and no one is suggesting you should put 100% of your portfolio in China. But with that valuation gap there is probably a decent case for a 10-20% allocation via a MSCI China index (diversification is the way to go for a know nothing investor without local market knowledge or political knowledge). Naturally things could get a lot worse but over a 10 year period you can expect a decent return from such depressed valuations.

Also yet another thing that will frustrate the usual transmission of monetary policy. What is the use of bank lending contracting and bank lending standards tightening if PE firms rush in and pick up the slack? Already credit spreads are much lower than you would expect them to be.

I think Yellen is the one pulling the strings pushing her agenda. And having worked on the other side she knows that the Fed will have to accommodate irresponsible fiscal policy which is why you are already seeing an accelerated taper and talk about cutting rates. One thing is clear, the US government is well aware that the voters still perceive inflation to be a major problem but refuse to accept any culpability for causing the inflation when it is Economics 101 that expansionary fiscal policy when the economy is at full employment is inflationary. Will be interesting to see how this plays out.

Fed could easily cut rates if the US government stopped printing multi-trillion dollar annual fiscal deficits. That is the real problem. But unfortunately there isn't an easy solution. Lower rates might massage the inflation figures temporarily but it would also trigger a spending splurge as people try to maintain a lifestyle via credit card debt that they can no longer afford as everything is so much more expensive post-COVID.

Shiller-CASE house price index peaked at 184 in 2006 and got back to that level by 2017 and then went to 215 before COVID hit. Currently stands at 312. So no evidence of massive building resulting from ZIRP post-GFC. But plenty of evidence that zero interest rates by increasing affordability resulted in house price inflation that took house prices well above the 2006 bubble peak even before COVID and that was during a period in which there was very little inflation or wages growth and that is clear if you look at house price to average earnings ratios which have been increasing throughout the post-GFC era. Lower interest rates would cause even higher house prices and even more positive wealth effects which is the opposite of what the Fed is trying to achieve even if it might massage the inflation figures to make them look better. There are vested interests that want house prices to stay high and therefore the housing shortage is unlikely to go away and with inelastic supply demand is going to drive house prices and lower interest rates increase housing demand. That is economics 101. And there is a problem if we are in a world where the middle classes can no longer afford holidays, nice restaurants, nice housing and all the other things that used to be part of a middle class lifestyle. And if the middle classes are struggling to get by then the working classes are in an even worse position. But the people living off government handouts are doing just fine. The tax burden is also a lot higher as a result of fiscal drag. And all the asset price inflation is massively increasing wealth inequality and also intergenerational equality.

2022 was an inflation shock. Long duration assets such as tech stocks and long bonds got destroyed. But we avoided a 73-74 scenario because of the pace of the disinflation and the economy holding up a lot better than expected. Yes there were signs of inflation before 2022 but everyone including the Fed assumed it would be transitory and the Fed didn't react. It was when the Fed realized it wasn't transitory and reacted by starting a rate hiking cycle that markets headed south. I also do not think it is relevant to talk about 2022. It was a shock that resulted from too much stimulus (demand side) before the supply side had the chance to recover fully from COVID. I think now we are probably in a moderate inflation environment. Ignoring valuations for now stocks tend to do well in such environments because they can usually pass on moderate cost inflation to consumers and grow earnings at a robust rate. Some bears have valuation concerns believing that equities are still priced for a return to a low interest rate low inflation environment. But outside of Big Tech valuations are probably already there and higher interest rates aren't an issue if they are because economic growth is more robust over the next decade compared to the anaemic growth post-GFC/pre-COVID. And arguably if AI does deliver its promise the rest of the market is undervalued as it will mean higher productivity growth and higher margins. As for Big Tech even if interest rates and inflation remain around 4-5% if they can grow earnings at a double digit rate (and again AI might extend the growth runaway the same way Cloud did) then they also look very reasonably valued if not cheap. I think the main worry for equities is that AI turns out to be a mirage and the real-world benefits are relatively limited. In this case higher inflation higher interest rates higher tax rates and having to refinance cheap debt will be major headwinds for the average stock. And for tech stocks they will be doubly punished: first, for making unproductive investments and second, when growth slows down in their core businesses and AI revenues fail to pick up the slack.

I'm not really seeing the appeal of intermediate or long bonds right now unless you are anticipating some kind of deflationary bust. But in that scenario long duration stocks such as Big Tech and bond proxies probably do a lot better. In a "higher for longer" scenario real returns will approximate zero in bonds and if the yield curve un-inverts the way it should then you could end up with unrealised losses until your bond matures. Equities generally do pretty well in a moderate inflation environment especially as it usually goes together with healthy economic growth. They can increase prices and volumes and that makes for very healthy nominal earnings growth. Many people thought the end of ZIRP would lead to multiple compression. But it hasn't in a meaningful way. And if inflation accelerates and interest rates need to go higher....well just think what happened to TLT in 2022 falling 50%.

I think Google and Microsoft results have done a lot to soothe investor concerns. Even Meta results were good and it was only the guidance that spooked investors a bit. We all know that Big Tech are investing heavily in AI. And the payoffs from those investments are uncertain and could be far down the line. But so long as the core businesses continue to grow strongly and there are some signs of incremental earnings growth from AI offerings then investors will be patient and continue to load up on Big Tech stocks. And it is a virtuous cycle (that could turn vicious)-the capex of companies like Microsoft, Google, Meta is the operating cash flows of NVIDIA and other hardware companies. For now the operating cash flow growth of chip companies gets rewarded by markets who extrapolate it far into the future (with no consideration over the fact that eventually capex spend will moderate or will get in-sourced to some degree). And the heavy capex spend (and resulting deterioration in FCF) of Big Tech is ignored or even welcomed by the market because optimism over AI means the expected payoff is supposed to be both imminent and high and the core businesses are still growing fast. And with Big Tech representing 1/3 of the market the considerations above are going to dominate the macro even if below the surface for the average stock the combination of stagflation and higher for longer interest rates and geopolitical tensions is a major headwind. The Mag7 index has gone up about 150% since the nadir in autumn 2022. The rest of the S&P 500 and other global stock markets have only started to see a meaningful recovery over the last six months as a result of central banks teasing a pivot and the emergence of some grass shoots in Europe and general optimism over AI.

If a company has a conservative capital structure such as a debt/equity ratio of less than 50% then P/E and P/FCF should work just fine. As for the OP's original question I've always felt you should anchor on what is real i.e. reported earnings. These should then be normalized for one-offs, cyclical factors etc. And then you consider qualitative factors such as growth prospects, competitive position etc in deciding what an appropriate multiple should be. Or if you have confidence in predicting the next few years earnings you can go a few years out and then apply an appropriate multiple. But as others have suggested better to come up with your own forward estimates rather than rely on Wall Street estimates as Wall Street isn't interested in accurate valuation it is interested in selling stocks. and no one sells stocks by indicating they are overvalued and forward multiples are great at making the valuation of fast growing stocks look more reasonable. And they play the same game with the S&P 500. At the end of every bull market Wall Street are still proclaiming that valuations are reasonable and forward PE ratios around in line with the historical average.

You are comparing nominal and real variables. Except for monetary regimes of financial repression (e.g. post WW2 and post GFC) the 10 year nominal yield has always been well above the real GDP growth rate (historical average around 3-4%). However if the yield curve un-inverts in a meaningful way there might be some scope to reduce rates 50-100bps or so. Anyway none of this really matters for the market. Fed fund rates has been above 4% for the last year and a half and during that time period a Mag7 ETF has gone up 150%. And with those kind of returns no one is going to care what your risk-free rate is or what inflation is. And even if you do think we are higher for longer and inflation is going to be sticky at around 3% to 4% why would you invest in a long bond and get real returns of approximately zero?

It comes with the territory. Investors do not just want high returns they want high returns without the volatility. They also want to get rich quick so find it hard to tolerate the inevitable downdrafts and dry spells. It is why people are such suckers for Ponzi schemes. And it is why companies feel pressured to manage earnings and waste a lot of time providing "guidance", "whisper numbers" and employ expensive investor relation teams. If you are going to be a growth investor the real money is made identifying companies with good long pull growth prospects and then buying and holding them for decades. Over that time period there are going to be lean years and fat years and many false alarms that indicate the growth is coming to an end encouraging a rush to the exits. For a quality growth stock you are much better off erring on the side of overstaying your welcome the way that Buffett often gets accused of doing.

Inflation isn't going to get back to 2% until government spending is brought under control and there probably will need to be a recession to achieve meaningful further disinflation. Unfortunately the Fed seem to have no further appetite for rate hikes and the US government will continue to spend because there is no one to stop them doing so. I can understand the desire to avoid the pain of a recession. But the alternative of getting stuck with 4% inflation for the next decade is much worse for the average joe even if investors will probably do just fine (it is high inflation not moderate inflation that kills the stock market). But what is pretty interesting is that we only managed 1.6% real GDP growth in Q1 with a government deficit of over 1/2 a trillion for the quarter with the economy at full employment (if you believe the official figures). Resilient consumer spending seems to be what is keeping the US out of recession growing at 2.5% for the quarter. Question is how long that can continue with job losses starting to rise and the saving rate at new lows.

Fed have already said that a worsening unemployment situation could justify a cut even if inflation remains sticky. But it is hard to imagine unemployment rising significantly when the US government continues to run massive fiscal deficits at full employment. So I expect US GDP growth to remain strong and US inflation to remain sticky and with that being the case agree that it is difficult to imagine more than a few cuts this year and probably towards the end of the year rather than in the summer. Something that does concern me a little is whether there is a "boiling frog" scenario. So far high interest rates haven't been a massive issue because a lot of companies and consumers are still benefiting from low-cost debt raised during ZIRP. But refinancing cannot be delayed forever and there is a lot of leverage in the system as companies and consumers and governments took advantage of ZIRP to pile on debt.