FT Alphaville is currently beavering away on a number of longer-term projects, which we hope to share with you soon, so sorry for the relative radio silence.
However, we just caught wind of a new note from GMO’s James Montier — one of various boffins in the storied firm’s Asset Allocation team who also, like the author, has a penchant for terrible shirts — which we thought was worth flagging.
His latest piece titled “Reasons (Not) To Be Cheerful” covers many of the bases you might expect from a seasoned equity market observer befuddled by a US stock market laughing in the face of a collapsing, or collapsed, global economy.
The US stock market looks increasingly like the hapless Wiley E. Coyote, running off the edge of a cliff in pursuit of the pesky Roadrunner but not yet realising the ground beneath his feet had run out some time ago.
Now one might explanation you might have heard for the parabolic market action is that the Fed, with its “money printer go brrrr” barrage of monetary stimulus, is propping up the market.
The problem with this explanation, as Montier notes, is that it doesn’t really make any sense.
For instance, when the Fed was shrinking its balance sheet between 2017 and 2019, stocks kept being stocks:
From a fundamental (there I go again, set in my old ways) perspective, it is tricky to argue for any direct linkage from the Fed’s balance sheet to equities. Most of the expansion of the balance sheet has been due to the various QE programs. And QE is really just a maturity transformation (ie, purchasing long-term debt and replacing it with the ultimate form of short-term debt, excess reserves).
We agree, it’s hard to draw a line between equities and QE. So what else could it be?
How about this: interest rates are a central component in the discount rate, through which all equities are theoretically valued. So surely, a lower discount rate means those future corporate cash flows are worth more, all else being equal, which is (theoretically) positive for stocks.
Not so fast, says Montier:
I have several issues with this viewpoint. First, as long-term readers will know, I am very sceptical of a clear link between bond yields and equity valuations. A little international perspective helps illustrate one of the reasons for my scepticism. Japan and Europe both have exceptionally low interest rates, mirroring the US, but they aren’t witnessing stock market valuations at nosebleed-inducing levels. Second, even if I accepted the link, there is the problem still that if the interest rate is low because growth is low, then the valuation is unchanged in a simple DDM [dividend discount model] framework (see “Role of Interest Rates”). And third (and in my humble opinion the killer blow for this argument), QE hasn’t actually managed to lower bond yields, which truly emasculates the argument.
So what’s up with US stocks then?
In FT Alphaville’s opinion, and Montier suggests as much, the Fed is one reason. Not because their policy actions matter a huge amount, but because investors believe they do. In short: the narrative that the Fed are willing to support equities is far more important to valuations than any of the any direct links between their policy actions and the market (such as ease of financing, discount rates etc.). As long as ‘don’t fight the Fed’ is the prevailing sentiment, then stocks will do well. And note, it’s an idea which reinforces itself as the market continues to go up, and the Fed, at the margin, continues to do more.
Figuring out what else is driving US equities, however, is tougher. We’ll leave you with Montier again, who doesn’t pull his punches:
In conclusion, it appears to me, at least, that the US stock market has priced in a truly Panglossian outcome with essentially a 100% probability. It is as if the market is taking a (good) tail risk and pricing it as the central case. This strikes me as extreme overconfidence, especially given the vast and imponderable questions that define today’s environment . . .
. . . Voltaire observed, “Doubt is not a pleasant condition, but certainty is absurd.” The US stock market appears to be absurd.