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Rational Exuberance


dpetrescu
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Can’t believe I missed this end of November 2020 article from Robert Schiller on Project Syndicate (mental note to read PS more frequently).

 

https://www.project-syndicate.org/commentary/making-sense-of-soaring-stock-prices-by-robert-j-shiller-et-al-2020-11

(Can read with free registration)

 

For the last year or so I haven’t been able to reconcile the market exuberance with the unprecedented low interest rates. The way Munger said in a recent interview that future stock returns will be lower in the next 10 years - and then abruptly corrected himself emphasizing “real” returns. The way Buffet always talks about the discount rate as gravity.

 

Schiller wrote the book Irrational Exuberance in 2000 right before the dot com crash. He then Created the Schiller index for real estate and wrote an updated version of the book - this time about the exuberance in real estate...right before the 2008 Great Recession. (His recent book is Narrative Economics.)

 

In his article he proposes a new measure (over the cape ratio) - the ICY inverted cape yield. Essential inverse of cape ratio - 10 year real interest rate. This would indicate (interpretation in my words)

1. This makes the exuberance in US stocks rational

2. Japanese and UKequities could be very significantly cheap right now

 

What does everyone think?

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Can’t believe I missed this end of November 2020 article from Robert Schiller on Project Syndicate (mental note to read PS more frequently).

 

https://www.project-syndicate.org/commentary/making-sense-of-soaring-stock-prices-by-robert-j-shiller-et-al-2020-11

(Can read with free registration)

 

For the last year or so I haven’t been able to reconcile the market exuberance with the unprecedented low interest rates. The way Munger said in a recent interview that future stock returns will be lower in the next 10 years - and then abruptly corrected himself emphasizing “real” returns. The way Buffet always talks about the discount rate as gravity.

 

Schiller wrote the book Irrational Exuberance in 2000 right before the dot com crash. He then Created the Schiller index for real estate and wrote an updated version of the book - this time about the exuberance in real estate...right before the 2008 Great Recession. (His recent book is Narrative Economics.)

 

In his article he proposes a new measure (over the cape ratio) - the ICY inverted cape yield. Essential inverse of cape ratio - 10 year real interest rate. This would indicate (interpretation in my words)

1. This makes the exuberance in US stocks rational

2. Japanese and UKequities could be very significantly cheap right now

 

What does everyone think?

 

In theory, I don't like using interest rates to determine the fair value of an investment.

1) rates change - sometimes dramatically and 2) low rates imply low growth which does NOT support inflated multiples.

 

In practice, low rates make businesses seemingly more robust (roll debt at lower and lower rates) and provide consumers with access to cheap financing which allows more spending in both the real economy and in capital markets. These are boosts to the capital markets and the economy.

 

But it's all fictitious - businesses/consumers lever way up b/c the cost of carry is so low and the entire foundation is precarious for even the slightest economic blip OR slightest rise in rates.

 

My preferred route is to have a reasonable, absolute discount rate and a reasonable expectation of growth/profits over the cycle.

 

Take all of this with a grain of salt though - my approach/concerns have cost me investment wise because I didn't appreciate that this could literally go on the better part of a decade. 

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It seems this topic interests practically nobody which means the topic is either irrelevant or supremely interesting. The point of this post is that you can make ANYTHING rational. In a way, that’s what Mr. Shiller is suggesting. It all depends on the underlying assumptions. The extent to which ultra-low interest rates have become justification for higher asset prices is puzzling, to say the least. Of course, interest rates act like gravity but this needs to be questioned IMHO, both for specific investment targets and for many markets indices.

 

In the last year, I’ve been involved in two private joint-venture transactions; asset-light and value based on return on capital, where the level of interest rates essentially played no role. Investment is kind of cool when it is most business-like. There is also one private investment i’ve been contemplating (commercial real estate) and i thought there was an opportunity recently (operational) but the price asked remains way too high because of the ultra-low interest rate environment. For the investment to be RATIONAL, the required assumptions include to have interest rates to stay very low for many reasons: to keep the interest burden on the leveraged transaction low, to have an unusually high amount of funding based on debt, to help justify a lower expected return on the total investment and to maintain a low cap-rate for the terminal value. And no consideration for the potential negative impact that ultra-low interest rates may have on the operational foundations (lease revenue) of the business. In the last few years, Mr. Buffett has expressed that he has had unusual competition for acquisitions in relation to this low-rate phenomenon even if “stocks are cheap because interest rates are low”. Unlike other acquirers who base their cost of capital on a high relative level of cheap debt, Mr. Buffett has mentioned that he always values deals as if funded entirely with equity. He has also said that, to discount future cash flows somehow, one has to use the prevailing long rates as a general guide but it seems he has always used a risk-adjusted margin depending on the transaction (this was discussed on the Altius thread at some point). Even if the return on equity required may have gone down because of the enduring low rate environment (this has been recently described by petec in the MKL thread), i would bet the relation between ROE decline and rates to be non-linear and perhaps detrimental, once certain levels are breached.

 

Anyways, this new-era-of-low-rates-justify-high-valuations for individual transactions often remains a puzzle and when used as a justification for high valuations for entire indices, then very unusual assumptions need to accompany the reasoning process in order to meet the ‘rational’ qualifier.

 

...

Japan's market has traded in the range of 25x for a couple of decades now.

 

Disclosure: I’ve been morbidly fascinated by the Japan bubble, its outcome and the way a new-normal-era has been defined.

 

In relation to this thread, the following is a piece of work ironically released at the height of the Japan bubble (Feb 1990).

https://dspace.mit.edu/bitstream/handle/1721.1/63287/arejapanesestock00fren.pdf%3Bjsessionid%3DF033E76A57BECD8D0068600D18A21E3A?sequence%3D1

TL;DR version. The authors sort of say that the rise in the Nikkei index in the late 80s (valuation wise, with reported PEs in the 50-60 area) was an unsolved puzzle to some degree but that it may have been entirely ‘rational’ with the following assumptions. Mr. Buffett wrote something similar in 1999 (market return expectations vs necessary assumptions).

1-Need to adjust down reported Nikkei PE ratios (by about 40%) because of accounting and tax rules differences

2-Need to integrate higher (and more optimistic) growth expectations (despite not being apparent or justified at the time), especially longer term

3-Need to integrate lower expected returns

 

Of course (we later realized), Japan markets in the late 80s were not rational and, perhaps, return to the mean overshot to some degree, but the reason markets went so high was because a material amount of investors, during the period, considered levels rational, given very specific and unusual assumptions. And the Cassandras of the time looked very stupid for a while as the levels of assumptions required grew substantially more extreme with market levels.

 

Looking at the math behind PEs, the authors did a good job at showing that simply making very small changes in long term assumptions for r and g, one could get into non-linear assumptions. Of course, non-linear assumptions are also potentially subject to return to the mean, and more. They also showed that assumptions 2 and 3 are not directly observable and cannot be really determined ex ante. I think that’s what Mr. Buffett means when he uses the rear-view mirror analogy.

 

So, what’s in store for Japan? I have no clue and specific investments may work out although unhedged transactions IMO remain potentially problematic over a reasonable investment horizon.

The Nikkei index has been trading at PEs of 20 to 30 (unadjusted) for the last few years. The assumptions for the market as a whole now need to take into consideration the following: the economy at large is facing unprecedented headwinds (getting older demography, gradually less productive, about to enter a dissaving phase, a growing gross net debt to GDP at about 270%, a growing net debt to GDP at about 180% (this was at 19% in 1990) and a progressively more hyperactive central bank (who holds about 45 to 50% of all JGBs, and about 6 to 8% of their entire stock market)). However, the required central underlying assumption is that ultra-low interest rates will continue forever and more. In fact, if one believes in the Nikkei and one is unfazed by the headwinds, it’s interesting to note that the 10-yr rate is now at 0.04% (versus 5% in 1989) so that if the gravity linear rule applies to interest rate to valuation (the reasoning room that Mr. Shiller opens), one could expect PEs to ‘rationally’ and potentially rise to 2500-3750. In the 1990 annual report, Mr. Watsa, when referring to the Japanese market, wrote: “No trees grow to the sky”. All that is required now is for the animal spirits to be released (at least that’s the message that been relayed for the last 30 years in Japan). Opinion: PEs of 20 to 30 in Japan now for the Nikkei may represent very significant overvaluation if one uses very reasonable assumptions. Of course, we will find out over time and this may help to clarify the ultra-low rate conundrum that has been in existence for some time now in various places. i politely submit that we (in the global sense of the term) have become prisoners of our own design but this posture has recently looked progressively more stupid so who i am to say?

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I think there is always some rationality to exuberance. And clearly in this case a combination of low interest rates and acceleration of secular growth trends has been very favourable to technology stocks and is expected to continue to be so. The irrationality will come from extrapolating recent growth rates and low interest rates too far into the future and paying too high a price for the favourable outlook. That will create a situation whereby any hint of interest rates rising or growth slowing will reset expectations and the hit to confidence will result in large share price declines.

 

 

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Saying something is expensive has no meaning in a vacuum. What we really mean is that it is expensive relative to something else. If the us dollar goes down - I think it’s implied that it goes down relative to the average of all the other currencies. But when all the other currencies are also going down, now we can say the dollar is going down relative to hard assets like real estate or solid companies that have a track record for high and growing earnings.

 

So when we say equities are overvalued. What does that really mean, overvalued relative to what? With this everything is relative lens,  I’m interpreting others to say:

 

1. Stocks are Expensive relative to potential future opportunities. So stocks now could be more expensive relative to stocks in 1 or 2 or 3 or more years. And to get that opportunity, I’m ok to have the certainty of losing no more than 1 or 2 % of value until then holding cash or bonds.

 

2. Stocks are expensive relative NOT to today’s actual real or nominal 10-year yields. But they’re expensive relative to an absolute discount that we can use now and always - to account for the fact that there’s just no way to predict future nominal or real yields.

 

3. Stocks are not expensive relative to anything else that has a long term track record. (I don’t think anyone else has said this yet)

 

Personally, I don’t feel great about either of the 3 above. The PE IN 1997 was the same but the y 10-year was 7%. And how can stocks not be expensive when we see AMC, BB and others double every day. Although By default I’m taking the #3 interpretation because I’m fully invested.

 

 

Which Warren Buffet and team do we listen to:

 

Use the same interest rate regardless if yields are 7% or 3% or 1%

 

Stocks “could be ridiculously cheap” assuming rates stay low for extended periods

And this is if 30 year rates are at 3 for a long time

 

 

Normally we would just say - who cares. But this is an era of all time rates, I think in this extreme case it warrants the question.

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