After decades of preaching profit margin reversion, GMO’s Jeremy Grantham just recanted (pp. 9-16). His first-order evidence is presented in Chart 1 below. Something is obviously different about “new era” valuations.
Chart 1. Higher and briefer valuation troughs
Grantham points to elevated profit margins, sustained by globalization, corporate political power, and most importantly, low real interest rates. These trends are likely to continue, in his view.
So, to summarize, stock prices are held up by abnormal profit margins, which in turn are produced mainly by lower real rates, the benefits of which are not competed away because of increased monopoly power, etc. What, we might ask, will it take to break this chain? Any answer, I think, must start with an increase in real rates….
Perhaps the best bet for higher rate equilibrium in the next few years is a change in the dominant central bank policy of using low rates to stimulate asset prices (which they clearly do) and stimulate growth (which, other than pushing growth back or forward a quarter or so, I believe they do not do). With 20 years of Fed support for this approach and loyal adherents in the ECB and The Banks of England and Japan, changing the policy is unlikely to be quick or easy. It is a deeply entrenched establishment view, or so it seems….
In conclusion, there are two important things to carry in your mind: First, the market now and in the past acts as if it believes the current higher levels of profitability are permanent; and second, a regular bear market of 15% to 20% can always occur for any one of many reasons. What I am interested in here is quite different: a more or less permanent move back to, or at least close to, the pre-1997 trends of profitability, interest rates, and pricing. And for that it seems likely that we will have a longer wait than any value manager would like (including me).
Our perspective? Navigating markets is always difficult. Every era presents new challenges. As we argued in July 2016, historically rich valuations should be viewed in context of today’s highly supportive monetary environment:
Given the growing importance of equity prices in monetary doctrine, investors should expect higher valuations at market bottoms, and perhaps also at market tops. If the “greatest crisis since the 1930s” produced a single-digit normalized multiple for only three short months, then routine market corrections are likely to bottom at much richer levels – perhaps in the vicinity of 15x normalized earnings. With respect to market tops, the old ceiling of 20x may no longer apply…. An equity multiple of 25x, or higher, is not irrational in the modern monetary environment.
Since offering this argument, our favored price-to-peak-earnings metric has risen from 20x to 23x.
Chart 2. S&P 500 vs. normalized P/E multiple
So the market is riskier than it was last summer. But no magic multiple dictates a top. An early exit in 1997 at the old ceiling of 20x, for example, forfeited a near doubling in price over the next three years. Ouch!
Valuation is crucial to asset allocation decisions. But it’s not the simple solution it appears to be. Price-to-earnings (however concocted) has a numerator and a denominator. The denominator is thought to justify the numerator, but the numerator also influences the denominator. And the numerator has become a matter of national policy.
As we quipped last summer, “We’re all momentum investors now.” To which we add the following corollary. If monetary policy is the key to mean reversion, “We’re all economists now.”
We applaud Jeremy Grantham for his critical thinking. It’s okay to revise an opinion, especially if you outline the factors that would make you wrong.