King of the Mountain (Arnott)

King of the Mountain (Arnott)

by Robert Arnott, Research Affiliates, (RAFI)

Most of us remember playing “king of the mountain” as children. The goal, often accompanied by a certain measure of roughhousing, was to summit a little hill and stay at the top while others vied to push us off and take our place.

King of the Mountain is not merely a child’s game. The U.S. stock market has been straddling a surprisingly precarious “mountain” in asset valuation for nearly two decades, resisting efforts to push us back below historical norms of valuation levels except for brief periods in 2002 and 2009.

We’ve written about the challenges over the past two years. In 2009, we described the coming “3-D Hurricane’s” soaring deficits and debts, in which we expect the post-baby-boom generations to pay down debts that we (1) promised to ourselves, (2) failed to prefund, and (3) failed to consult the generations that will be expected to honor these debts. In 2010, we addressed the consequence of soaring debt burdens in most of the developed world, as compared with the generally well-managed debt burdens of our primary external creditors in the developing world. In this issue, we explore the challenges to our lofty perch in the equity markets. Specifically, we examine the potential consequences of understated inflation and toolow real interest rates, paired with a Fed policy that seems intent on further boosting inflation and eroding real interest rates.

The Valuation Mountain

First, let’s look at how real interest rates and inflation affect valuation multiples. Some years ago, Marty Leibowitz and Anthony Bova pointed out a “hill” in valuation multiples.1 When real interest rates—which we define as 10-year Treasury bond yields less the trailing three-year average Consumer Price Index—are midrange, suggesting solid economic growth, the stock market sports a robust P/E ratio, often well above 20 times earnings.2 When real interest rates are either negative (reflecting a desire to aggressively stimulate the economy) or unusually high (reflecting a desire to rein in an overheated economy), the average P/E ratio plummets below 11.

The real-rates valuation hill is illustrated in Figure 1. It’s quite a lofty hill. Over the past 140 years, whenever real short-term interest rates have been in their 3–4% “sweet spot,” the market has exhibited a price 21 times 10- year smoothed real earnings. At real interest rates that are either lofty (above 6% in real terms) or negative, the average P/E ratio

tumbles to 11. If we limit ourselves to more recent results—over the past 50 years—we find that the peak is a little bit taller, with more tolerance for slightly lower real rates. But the shape of the curve changes remarkably little. It’s also very interesting to note that this valuation hill accounts for some 40% of the variation in P/E ratios. Real interest rates really matter to equity valuations.

It turns out that there’s another valuation hill, related to the rate of inflation. Of course, inflation generally moves in opposition to real rates: when inflation rises, often real rates fall, until the Fed decides to do something about it. In some ways, this second hill is even more powerful than the real rates hill. As we can see in Figure 2, the peak is taller, with typical P/E ratios of over 23 whenever inflation is 2–3%. However, high inflation is far more damaging to P/E ratios than high real interest rates: When trailing three-year inflation is above 6%, the P/E ratio plunges to an average of 9.4 times average 10-year real earnings.

Because real interest rates and the rate of inflation are negatively correlated, the two hills combine to create an impressive three-dimensional mountain, formed by plotting P/E ratios against both real interest rates and inflation (see Figure 3). Of course, there are some scenarios that either never happened or almost never will.

When real rates are 3–5% (moderately high) and inflation is 1–3% (reasonably benign), the average P/E ratio is 26. But it’s a sharp peak. When real rates are a bit lower (1–3%), the average P/E ratio drops to 19, a drop of more than 25%. When real rates are high (above 5%), the average P/E ratio nearly halves to 14. When inflation is a bit stronger, the average P/E ratio drops to 20; when inflation is a bit weaker, the average P/E ratio drops to 17.

The linkages are strong. The correlation between the indicated P/E ratio drawn from this valuation mountain and the actual Shiller P/E ratio is 68%. To be sure, this is an in-sample comparison, but even after adjusting for overlapping samples, we get a t-statistic of over 7 for this comparison—a strong confirmation of the validity of the data. The bottom line: over half of the variability in P/E ratios over the past 140 years can be explained by real interest rates and the rates of inflation.