Summary

• By most measures, the U.S. stock market is either the most expensive or second most expensive in U.S. history.
• Interest rates and corporate tax rates have had a big impact on equity valuations over the past 10-20 years. Not globalization.
• An updated look at coronavirus impacts on the global economy.

As we move deeper into 2020, it’s a good time to provide an update on U.S. equity valuations.

Stocks are very expensive by most metrics, but there are many different opinions on how to value them and how highly they should be valued. So, this newsletter issue takes a look at current equity valuations from a few different angles, and then provides an update on ongoing coronavirus impacts.

Distance from an Idealized Market

In a healthy and well-ordered market, equity securities should ideally provide higher forward returns over the long run than long-term investment-grade fixed income securities, long-term fixed income securities should ideally provide higher returns than short-term fixed income securities, and short-term fixed income securities should ideally provide higher returns than gold.

This should be intuitive. Equities are volatile and are at the risky end of the capital stack; the last people who would get any money back in the event of a bankruptcy, compared to corporate bondholders and other lenders, and especially compared to investors in the nominally “risk free” asset class of government bonds.

Long-term fixed income securities make you lock up your lending period for a longer period of time, which inherently means more risk, and thus should demand higher yields than short-term securities of the same level of current credit risk. In other words, lending money for 10 years should earn you higher yields than lending to the same borrower for 1 year. However, especially with modern financial vehicles like ETFs, many investors don’t hold such securities to maturity and instead trade them around.

Lastly, gold has no yield and incurs a small storage cost. So, when the financial system is healthy, gold should provide lower returns than fixed-income securities.

In general, riskier or more volatile asset classes should provide better long-term returns than safer or less volatile asset classes. If this doesn’t occur over, say, a decade, then most likely one or more of the asset classes was misjudged or mispriced from the starting point.

During many periods in history, markets are not healthy and well-ordered, and instead become sick and imbalanced. Equity valuations get too high, for example, and therefore end up underperforming bonds and/or gold over the next decade or longer. Yield curves sometimes invert, meaning that long-term securities pay lower yields than short-term securities. Inflation switches from low to high, or debt defaults occur, and therefore bonds end up underperforming gold. Interest rates on cash and bonds sometimes go below the inflation rate, meaning that gold suddenly becomes a lot more attractive as a store of value.

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