It’s become fashionable in the financial press to dismiss the near supernatural level of US stock market valuation by countering that you have to consider interest rates. At these low rates, it’s suggested, stock valuations are reasonable. Whether on price to sales, price to dividends, or whatever, the context of low interest rates means stock prices are just fine at these stratospheric levels.
Let’s unpack this. Given the inverse relationship between price and yield, low interest rates mean high bond prices. The argument boils down, therefore, to don’t worry about high stock prices because bond prices are really high too.
So what’s wrong with this argument? Let me count the ways. First, it tacitly assumes that there aren’t any other investments besides stocks and bonds. Since the total of stocks and bonds in a portfolio is automatically 100%, if bonds and stocks are both overvalued then it makes no difference to your asset allocation. The flaw in this is so obvious no further comment is needed.
Second, there’s a more subtle issue being completely ignored. Even if the only options on the investment menu were stocks and bonds, and that bonds are just as overvalued as stocks or even more so, the argument assumes that a reversion to normality in bond valuations would result in just as large a decline in bond prices as in stocks.
Not so. The reason for this is duration. Bonds are typically much shorter duration assets than stocks. This means that a commensurate rise in yields for both bonds and stocks would result in a much smaller price decline for bonds. A portfolio of Treasuries, for example such as the iShares Treasury index fund GOVT, includes a range of maturities from one to thirty years. While the long end of this range may have durations comparable to stocks, it’s only part of the portfolio; the rest of it is shorter. Even in the event valuations simultaneously contracted in both by the same amount, the bond portion of the portfolio would decline by much less in price. And this ignores the tendency of bonds to zig when stocks zag, that is, a negative correlation over relatively short time frames. The result is that including Treasuries in a stock portfolio – even if they are as richly valued or even more so than stocks – nevertheless reduces risk.
The bottom line is that an overvalued stock market and an overvalued bond market means returns on a portfolio of stocks and bonds are likely to be well below their historic rates. Rather than jump to the conclusion that low interest rates don’t justify caution in allocating to overvalued stocks, isn’t the more sensible takeaway that maybe some other assets should be considered?