2021-03-18

The Dow 36,000 Market

The Dow 36,000 market is setting investors up for destruction:
One of the unfortunate bits of financial illiteracy that Wall Street has pushed into the heads of investors is the idea that extreme valuations are “justified” by low interest rates. Now, it’s certainly true that, holding future cash flows constant, raising the price of an investment will lower the embedded rate of return, and vice versa. If you pay $32 today for $100 a decade from today, you can expect a 12% annual return. If you pay $82 for the same security, you can expect a 2% annual return. If you pay $100 today, you can expect nothing. So it’s clearly true that, holding future cash flows constant, a lower rate of return implies a higher level of valuation.

The reason the statement “low interest rates justify high valuations” contributes to financial illiteracy is that the statement has been learned entirely out of context of the arithmetic. As a result, investors seem to imagine that, as long as high valuations can be “justified,” stocks can be expected to provide historically normal rates of return in the future. Likewise, investors seem to have no concept that if interest rates are low because growth rates are low, no valuation premium is “justified” for stocks, because the lower growth is already sufficient to bring future stock returns down to levels that are commensurate with the low level of interest rates.

The truth is simple but uncomfortable. If interest rates are low and expected growth is held constant, higher valuations imply lower long-term returns. If interest rates are low because expected future growth is also low, higher valuations are not required. Long-term returns will be lower anyway. A valuation premium just makes future returns even worse.

Saying that extremely low interest rates “justify” extremely high stock valuations is identical to saying that extremely low future returns on bonds “justify” extremely low future returns on stocks. I don’t really think that’s something Wall Street cares to clarify when it tells investors that stock market valuations are “justified.”

How to Spot a Bubble

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