Random Thoughts From The Frontline

Random Thoughts from the Frontline

Rather than going deep into one theme, this week we will do a “Random Thoughts” from the Frontline. Today we will cover several topics in shorter form: valuations, infrastructure, the debacle in Texas, and a lot more. Let’s jump in.

What Is Fair Value?

Many analysts contend that current stock valuations resemble the dot-com era. You can see it visually at Current Market Valuation. Here are just a few of the many charts on the website.

Let’s start with the classic “Buffett Indicator.” It certainly seems to be in nosebleed territory. Notice that the valuations in 1966, the beginning of a long-term bear market, were also high.

Source: CurrentMarketValuation.com

Then there is the ever-popular price-to-earnings ratio. Notice by this measure that valuations were not all that stretched in 1966. Yet there still followed a 17-year bear market, as measured from the peak back to where it started.

Source: CurrentMarketValuation.com

This next one is unusual: valuation as measured by mean reversion. Mean reversion is the fairly unsophisticated concept that "what goes up must come down." While the market’s day-to-day movements are chaotic, long-term stock market returns tend to follow somewhat predictable upward trends. But they can also deviate from the trend for years or even decades.

This isn’t a trading strategy. But it's still a useful indicator of overall market valuation relative to the past. Here we see that in 1966 and early 2000, the S&P 500 was two standard deviations from the mean. As of last Friday, it is almost back to that level.

Source: CurrentMarketValuation.com

But this is not your father’s or your grandfather’s overvalued market. There are two major differences between today and those previous periods. First, in the dot-com era, the Federal Reserve had let loose the dogs of easy monetary policy going into the Y2K event. That was appropriate given the uncertainty, but it clearly helped send already overvalued markets to extremes.

We had day traders piling into anything that looked like an Internet stock, speculations, really easy money, and so forth. Then after Jan. 1 passed uneventfully, Greenspan appropriately reversed the Fed’s monetary policy.

And now we have enormous federal government stimulus, soon to be about 25% of GDP in less than a year. That money ends up somewhere, but its impact is still unclear. There is no historical parallel to consider.

Which of These Is Not the Same?

For those of us with children a few decades ago, and I assume the same today, there were educational books showing a series of pictures and asking which of these is not the same? We can also ask this about our current stock market situation. Jerome Powell is not Alan Greenspan.

Powell and his colleagues have made it very clear they will keep monetary policy loose and rates low for a very long time. Inflation is well down their worry list. Their top concern is unemployment, which is indeed a real problem. The Fed is telling us it will let inflation get to 3% or more. They are looking at the average inflation over time, which means they can justify doing anything they want.

What they want is low rates, even if it overheats the economy, until unemployment returns to where it was before the pandemic. If they really mean that, then we are going to have low rates for a very long time, as unemployment is a bigger problem than most people think. It also means, maybe not coincidentally, the US Treasury will find it easier to refinance an ever-increasing federal deficit.

But persistent low rates might mean stock market valuations are actually in the fair value range. Look at this next chart showing S&P 500 value relative to interest rates. Interest rates are 1.6 standard deviations below the trendline. That suggests that the S&P 500 may not be so overpriced.

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Disclaimer:The Mauldin Economics website, Yield Shark, Thoughts from the Frontline, Patrick Cox’s Tech Digest, Outside the Box, Over My Shoulder, World Money Analyst, Street Freak, Just One ...

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