US stocks have been expensive for about 20 years...
U.S. STOCKS are expensive, writes John Stepek, editor of MoneyWeek magazine.
Few people disagree with this assertion.
You can measure it almost any way you like and your conclusion has to be that US stocks, relative to history, are valued highly right now.
What people disagree on is how sustainable this level of valuation is.
And that – at least partly – boils down to the simple question: "Why?"
Why are US stocks so expensive? My go-to source on all things value-related is Jeremy Grantham, bubble expert and founder of US wealth manager GMO.
As a value investor, Grantham hasn't been having much fun with the persistently expensive US market. And he points out that the US market has been overvalued for a long time.
From 1935 to 1995, he notes, the S&P 500 (the main US market) oscillated around an average price/earnings (P/E) ratio of just under 14. One of the core tenets of value investing is the idea of "reversion to the mean" – the idea that it's never "different this time" and that history will out.
So if the P/E of the US fell significantly below 14, a value investor would probably buy the US market, expecting it to return to its average valuation. Similarly, they would avoid it, if it rose much above 14.
However, starting from around 1996, notes Grantham, something appears to have changed. For the past 20 years, the market's average P/E has been just above 23. That's a big jump, and it's been sustained for a long period.
Equally, during that period, the market has only very briefly been anywhere near the old average of 14, even after the massive bust of 2008. And it has pretty much never been "cheap" by pre-1996 standards for that entire time.
So what, if anything, has changed?
Well, one big factor is that US companies have become a lot more profitable. Profit margins have risen sharply. The return on sales for the S&P 500 has gone from an average of 5% to an average of 7%.
That's important. At the end of the day, you own shares in order to lay claim to a chunk of corporate profits. The more profit a company makes and the more reliably it can produce that profit, the more valuable its shares. So if the profitability of the average listed company rises sharply and sustainably (as appears to have been the case), then the value placed on equities in those companies should rise too. As Grantham puts it: "With higher margins, of course the market is going to sell at higher prices."
So why has this happened – and is it likely to change?
Something very obvious has happened over the past two decades. Interest rates have been spectacularly low, with financial repression raised to an art form by Alan Greenspan. These low interest rates combined with higher borrowing have been a huge help to company profitability. In fact, it's "the single largest input to higher margins".
However, that's not a satisfying answer by itself. You see, says Grantham, in a competitive business environment, this benefit from lower interest rates should have been competed away. The higher margins should not have been sustained for this long.
So what it boils down to, argues Grantham, is that corporations have also enjoyed increased power, which has enabled them to maintain the higher margins that they've achieved through ultra-low interest rates.
Globalisation has helped a great deal – it makes branding more valuable, and the US has lots of brands (Coca-Cola, Amazon, Google, etc). And it has made labour a lot cheaper – with a global pool of workers to choose from, wages have been suppressed across the board.
Grantham also argues – and this one is harder for me to judge, as an outsider to the US – that companies have accrued more political power over the past couple of decades. Basically they have much more monopoly power than they once did.
What might change things?
Higher interest rates are the obvious answer. But that might not happen for a long time, and when rates do rise, they are likely to peak at lower levels than in the past. As a result, Grantham reckons we're more likely to see a slow decline towards cheaper – but still expensive relative to the old days – valuations, rather than a rapid collapse.
Beyond that, a shift in power from corporations to workers would probably change things. I think it's a mistake to get too carried away with the similarities behind Donald Trump's election, Brexit, and the growing popularity of Marine Le Pen – they each have quite distinctive driving forces behind them.
But if the current wave of populism has any underlying principle that unites it across the board, then it's the idea that the "little guy" has had a raw deal. That might be deluded or purely the politics of envy, but it's a real phenomenon, and if Grantham's point about growing corporate power is right, then it's no wonder that the "little guys" feel so hard done by.
So change might come through the political system rather than the central banks. There's not much evidence of that yet. But I'd keep an eye on inflation.
You see, it doesn't take a Jeremy Corbyn to undermine corporate power. Trump is hardly a socialist, but many of the policies he espouses – protectionism, big government spending – would be inflationary and likely to drive up the share of profits going to workers rather than capital.
Yes, he's failed to drive through any of those policies. But it's worth remembering that people voted for them.
If he doesn't act to change things, then maybe someone else will.