By John Kemp
LONDON (Reuters) – U.S. equity prices are increasingly deviating from their multi-decade trend, implying there has been a fundamental shift in valuation, or the market has become overheated and risks a sharp downward correction.
Since the 1920s, the broad-market Standard and Poor’s 500 equity index (S&P 500) and its predecessors have increased at a compound average rate of 6.8% per year, reflecting the growth in economic output and the impact of inflation.
The index has exhibited large and sustained deviations from trend, sometimes lasting years or decades, but has proved consistently trend-reverting, implying valuations are anchored in fundamentals over the long term.
But in the 12 months to the end of August, the index rose by nearly 20%, one of the fastest increases in the last decade, and a significant turnaround from the market slump in February and March.
By the end of August, the index was 34% above its long-term trend, the largest positive deviation since October 2007, shortly before the subprime housing bubble burst and the business expansion ended.
The index’s positive deviation was in the 90th percentile for all months since 1930, indicating it was richly valued, with an above average risk of correcting lower in future.
The only period when the index exhibited a larger and sustained positive deviation was between late 1996 and early 2002, the era of “irrational exuberance” culminating in the dotcom bubble and its aftermath.
MONETARY EASING
The duration and magnitude of the deviation from trend during the late 1990s and early 2000s should serve as a warning that mean reversion does not always happen quickly.
In the late 1990s, equity valuations were boosted by sharp reductions in interest rates as the Federal Reserve sought to keep the business expansion going and address liquidity risks within the financial system.
The Fed responded to the Asian financial crisis, Russian debt default, failure of Long-Term Capital Management, Year 2000 computer problem and bursting of the dotcom bubble itself by cutting rates and pumping liquidity into the financial system, prolonging the positive deviation in equity markets.
Nonetheless, the record-breaking positive deviation ended in a reversion to trend by the end of 2002 and early 2003 (https://tmsnrt.rs/2QTUzUd).
The current large positive deviation poses the question whether something fundamental has changed, or whether equities have become increasingly overvalued and a reversion closer to trend is increasingly likely in future (though the timing would still remain uncertain).
On the fundamental side, the Fed’s easing of monetary policy and its adoption of a new policy framework committing the central bank to a more relaxed policy in future could both support higher equity prices.
The reduction of returns on risk-free assets such as U.S. Treasury securities is pushing investors into riskier assets such as equities while reducing the discount rate on future corporate income streams and boosting valuations.
The Fed’s aggressive relaxation of monetary conditions in 2020 could be elevating equity values in the same manner as its monetary easing in 1998/99 and again in 2001/02.
BLOWING BUBBLES?
The revised monetary policy framework implies interest rates will be lower for any given rate of output growth and inflation than they were in the 2000s or the 2010s.
The Fed will try to run the economy at higher levels of capacity utilisation and employment without worrying so much about potential future inflation. Lower interest rates imply higher asset values, other things being equal.
If so, the positive deviation could remain, and even increase for months or years, before eventually reverting towards trend.
But the experience of the late 1990s also provides a warning: monetary policy cannot inflate asset values indefinitely without creating serious distortions and risk mispricing.
In the last century, the larger the positive deviation from trend, the larger and sharper the subsequent correction has been.
Like fiscal policy, monetary policy alters the distribution of income and wealth as well as the flow of funds around the economy.
But monetary policy does not, in itself, change the underlying technology and productivity-driven growth rate, or the long-term increase in value-added and asset values.
In the middle of a pandemic that is profoundly disrupting the economies of the United States and its trading partners, investors are pricing in a multi-year period of strong non-inflationary output growth, ultra-low interest rates and corporate value creation.
(John Kemp is a Reuters market analyst. The views expressed are his own)
(Editing by Emelia Sithole-Matarise)
