As follow up to my last post regarding cost of equity and valuation multiples for the S&P 500, here is a chart showing the implied steady state PE versus the actual PE for the index since 1961.

The actual multiple typically plots above the steady state estimate. This is to be expected since the market is typically assigning some value to future earnings growth, and for simplicity’s sake my steady state multiple calculation does not factor in future growth.

By calculating the steady state multiple in this way you can easily visualize how the market is valuing future growth at a point in time. When the actual multiple is far above the steady state multiple, as in the late 1990s, the market is assigning a high value to future growth. Obviously the value of future growth can swing around violently depending on investor sentiment. In fact, exploiting this tendency for the market to overvalue and undervalue future growth is the lynchpin of Ben Graham style value investing. If you buy a stock at a low steady state valuation, yet have correctly discerned there are future growth opportunities not reflected in the market price, you get a free call option on the future.

The impact of ultra-loose monetary policy shows up very clearly in this chart in 2009. The steady state multiple shoots up dramatically in 2009 as interest rates (and thus discount rates) hit historic lows. What is interesting to me about this chart is how long the actual multiple remained below the steady state multiple, almost as if the market “realized” the discount rate had been artificially manipulated and refused to play ball. Again, that speaks to the power of investor sentiment.

Superficially, it appears as though the market valuation has finally “caught up” with its steady state value and has room left to run (remember, the steady state model isn’t pricing any growth). However, as discussed in the previous post, the steady state multiple has risen due to a low discount rate. So what I think investors need to think long and hard about today is whether we are systematically mispricing risk (spoiler alert: I think we are).

That said, I don’t think investors are mispricing risk because they are stupid, or even because they are greedy. In fact, I think they are acting rationally in the face of unappealing alternatives. But that is a subject to explore in future posts.

I want to share a chart I believe is of paramount importance to asset allocation and valuation in today’s environment. It graphs the implied cost of equity for the S&P 500 alongside the steady state earnings multiple that number implies. The underlying data is from NYU Professor Aswath Damodaran and the steady state calculation is taken from a paper by Credit Suisse’s Michael Mauboussin.

Professor Damodaran estimates the implied cost of equity for the market by solving for the discount rate that sets the present value of projected S&P 500 dividends equal to the current level of the index. There are plenty of quibbles you can raise with this simple model (as with all models it is a dramatic oversimplification of messy reality). However, I don’t believe quibbles diminish the key insight.

Namely: the implied valuation of the equity market moves inversely to its implied cost of equity. This should make intuitive sense to anyone who has ever discounted a cash flow. If you were wondering, the calculated correlation is around -.90.

Here is my chart:

What this chart makes abundantly clear is that over the past thirty years the justified steady state multiple for the S&P 500 has crept steadily upward. Not so much because the risk premium has contracted but because the T-Bond rate (used as proxy for the riskfree rate of interest) has come down dramatically.

Now, that is a fairly superficial observation. Why does it matter?

Reason #1: A popular contrarian narrative in the markets is that central bankers have artificially suppressed interest rates, and that absent their interventions the “natural” rate of interest would be higher (implying a higher discount rate and thus lower sustainable valuation multiples). The key risk to this thesis is that low rates are not some exogenous happening imposed on the market by a bunch of cognac swilling technocrats, but rather a consequence of secular shifts in the global supply and demand for funds. Specifically, that these days there is a whole boatload of money out there that needs to be invested to fund future liabilities and too few attractive investment opportunities to absorb it all.

If low rates are actually a function of the supply and demand for funds, it doesn’t ultimately matter what central bankers intend do with monetary policy. Market forces will keep rates low and elevated valuations will remain justified.

Reason #2: Capital is allocated based on the opportunity set across asset classes. A 5% implied IRR on the S&P 500 may suck wind relative to “normalized” risk, but it is better than what you can expect in bonds. As long as equity looks like “the least bad alternative” valuations will remain elevated. If you are trying to short the market into this dynamic you are going to have a brutal go of it unless you are extremely fortunate in your timing. This is precisely why so many bearish investors have been wheeled out of the market on gurneys over the past 5 years.

Reason #3: By way of anecdotal evidence, sentiment is getting more and more bullish. Every day I am reading articles about the possibility of a market “melt-up.” If the market melts up it may narrow the implied risk premium and further reduce the implied discount rate. If this occurs, it leaves investors even more exposed to a double whammy: simultaneous spikes in both the riskfree interest rate and the risk premium. The years 1961 to 1980 on the chart give you an idea of how destructive a sustained increase in the discount rate can be to equity valuations.

My overall assessment of today’s markets is that perceived risk is low across the board. As a result investors are not generally being well-compensated for the real risks embedded in their portfolios.

Some Acknowledgements

This post is a synthesis of many arguments I have read over months and years. I therefore want to credit Josh Brown, John Hempton, Philosophical Economics, David Merkel and GMO for their tremendously insightful comments and analyses, which have helped me get to grips with the “real world” supply and demand fundamentals underlying today’s market valuations.