The 2008 financial crisis was, at least in part, due to a fundamental flaw in the pricing of Credit Default Swaps on housing lending. Analysts who justify the current rise in markets on falling interest rates are making a similar error.
A (very) brief history of credit default swap pricing
I won't go too deeply into the models, but you do need some background.
There is nothing intrinsically wrong with a credit default swap, or CDS.
The problem in the early 2000s was pricing models for credit default swaps assumed housing defaults were independent. i.e. that someone defaulting on a loan in Miami was unrelated to someone defaulting on a loan in San Francisco. In essence, the pricing models ignored the possibility of a housing market downturn that spanned the US.
Armed with this fallacy, banks could then "safely" lend far more than was reasonable and embarked on a massive lending spree.
Spoiler alert: the loans were not safe. The bankruptcies and the unwind of this lending was a significant cause of the financial crisis.
A (very) brief history of the lower interest rate argument
Falling interest rates have been credited by many with the rise in the stock market.
The operation is relatively mechanical, a discounted cash flow model takes future expected cash flows and then discounts them to give a current market value:
The mathematical effect of lower interest rates is that it increases the current market value.
We saw the effect Wednesday in Australia when lower interest expectations led to a broad market bounce.
Problem #1 with interest rate argument: Inflation
The most obvious problem with this analysis is that there is no context.
The only reason interest rates are low is because inflation is so low. i.e. declines in the growth rate of the cashflows simply due to lower inflation offset part of the benefit of lower interest rates.
Central banks simply cannot generate inflation, despite a dozen years of trying since the financial crisis.
Net effect: If inflation is going to be lower, then cash flows are also going to be lower, offsetting some of the valuation impact of lower interest rates.
Problem #2 with interest rate argument: Real growth
The same logic extends to the real (i.e. inflation-adjusted) growth rate of companies.
Not only is inflation low, but rock bottom interest rates reflect poor economic growth across the economy.
Net effect: If real economic growth is going to be lower, then cash flows are also going to be lower, offsetting some of the valuation impact of lower interest rates.
Problem #3 with interest rate argument: Distribution
In my view, discounted cash flow analysis is an excellent tool for evaluating bonds where the cashflows are known in advance.
That is not the case for shares.
With shares, each cash flow is uncertain. For a single period, we can express this as a distribution of likely outcomes:
And then multiply this effect for every year where there is a forecast.
How do practitioners get around this uncertainty?
Poorly. To reflect the uncertainty of the earnings, analysts add a risk premium to the discount rate to drag the future value lower:
So, facing increased uncertainty, there should be some increase in the risk premium to offset the fall in interest rates.
Net effect: If economic uncertainty is higher, then the market risk premium should also be higher, offsetting some of the valuation impact of lower interest rates.
Problem #4 with interest rate argument: Corporate debt
I won't go into the specifics, but the way most analyst's discounted valuation models work, a higher debt rate serves to decrease the discount rate and make the valuation higher.
There is a reasonable basis for this with low or average debt levels. Corporate debt is not low or average; it is high:
More debt changes the likely distribution of cash flows. It turns the distribution from a more even set of outcomes to give both a wider range and a higher likelihood that companies go broke:
So, when there is a lot of debt and the growth rate falls, then the chance of companies going broke increases. i.e. the effect of lower growth on likely outcomes is different depending upon how much debt is in the system.
Net effect: If corporate debt is too high, then the market risk premium should also be higher, offsetting some of the valuation impact of lower interest rates.
Problem #5 with interest rate argument: Negative outcomes
People don't like to lose money. Numerous studies show the psychological pain of loss is higher than the pleasure of gains.
In a big picture sense, you will be prepared to pay a certain price for a volatile investment where you expect a return of 7%, but can reasonably expect the outcome to be between (say) 0% and 14%.
If you now lower the expected return to be 4%, the range is -3% to 11%. Arguably you should weight the greater risk of negative outcomes more heavily, and so increase the market risk premium.
Net effect: If expected returns are low, then the market risk premium should be higher, offsetting some of the valuation impact of lower interest rates.
Problem #6 with interest rate argument: Japan
This is complicated by the fact that Japan was in a stock market bubble as interest rates started fall.
But, if anything, the experience in Japan was that lower interest rates led to lower share market valuations, not higher.
Net effect: Lower interest rates in Japan have led to lower valuations.
Exceptions to the rule
Every rule has an exception. In this case, if interest rates are to remain lower for longer but you can find a company with stable earnings, little debt and a decent growth rate, then there is an argument for higher prices driven by lower interest rates.
There are a reasonable number of stocks in the tech sector where this logic applies. There are also a large number of stocks in the tech sector trading as if it were true even though it isn't.
One more aside on discounted cash flow valuations
From an earlier post, a reminder that discounted cash flow (DCF) valuations are really, really easy to manipulate to get just about any answer you want:
Final word on lower interest rates
To the surprise of some, more bad economic news does not mean that stocks should go up.
I disagree with, but can at least understand the arguments that say markets should be higher because either:
- governments and central banks have overstimulated in the short term and there is too much money in the system
- there will be a sudden recovery in the economy
But, I can't understand those who justify rising stock markets solely on the back of a worse outlook for long term interest rates.
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This is excellent
devil's advocate: 1) Inflation & growth are at structural lows, but also cyclical lows. Assuming there'll be no growth forever ignores the cyclical nature of current growth rates. Assuming one of the many vaccines works, growth rates will somewhat recover - a 0% discount rate doesn't factor this in - central banks will deliberately remain behind the curve. The dividend yield on the ASX is over 3% (unfranked). If it's sustainable, isn't this a gift, in the context of term rates at 0.5%? If the cash rate ever rises, company dividends will be growing, too. 2) Inflation targeting has moved higher (Fed looking for over 2%). The price of money is therefore lower than it was before, and so by default the value of assets in money terms must be higher. This is artificially imposed by the Fed, and not necessarily an inherent reflection of forever-lower economic growth. 3) Company valuations are always overvalued, but it's never talked about because of survivorship bias in market indexes. If the Dow Jones still reflected 1990 constituents, not many people would invest in shares. Indexes outperform active managers because active managers are left holding the bag of deteriorating value companies in sunset industries, while the index machine moves on. Yes, many high flying 'tech' companies will fail, but they've always failed, and indexes just turf them out. Only now valuations appear egregious because these companies' forecast market share gains are quite rightly valued stratospherically because money. is. free. Some will win and deserve outrageous valuations. 4) Why is uncertainty higher now than at other times? Why is the market risk premium higher now than previously? January 2020 was, in hindsight, a period of enormous uncertainty, only the market didn't realise it. If anything, it can be argued that current risk premium should be lower, because central banks and governments have delived a chunky put option to asset holders, while post-vaccine economic outcomes are not reflected in asset prices. 5) Corporate debt is higher because interest rates are lower. The cost of borrowing is lower. Central banks are buying debt too. Why is the risk of corporate default higher than before? 6) Asset valuations are made in the context of portfolio construction, and also attempt to remove psychological biases - if they weren't, then they'd be pretty useless. Why should the probability of negative return in a single asset receive special treatment? Is this perhaps why value stocks are now priced a lot lower relative to growth stocks? Perhaps. Distressed assets are often irrationally discounted. But then again stud assets are often irrationally overpriced, so a one-sided adjustment lacks empirical evidence. Adjusting mathematical valuations for perceived loss aversion is also dangerous because defining a loss is hard. If an asset has a -1% growth rate, but economic growth is -2%, is this a loss? Only if the -2% economic growth rate is unknown, perhaps, along with many other factors. 7) As said, Japan was in a gigantic asset bubble, and it never cleared because Japan is not a capitalist economy (turns out no economy is). Also, Japan has zero immigration, declining working population, no labour market pricing (jobs for life), and most companies operated for local customs and power systems, not capitalist principles. What's happened is exactly what you'd expect to have happened in Japan - it's not particularly mysterious. Is Australia Japan?
Thanks Will for the detailed thoughts. I don't want to discount your attempt to play devil's advocate, but I'm not sure that you are actually doing so. The premise starts with bond markets decreasing interest rates because of concern about inflation and growth. Then, I'm arguing about what is an appropriate response to that. Your argument seems to be that bond markets are wrong and inflation and growth are fine. If you reject the initial premise then you are not playing devil's advocate about what is an appropriate stock market response. You are instead arguing that my suggestion about what is an appropriate response is doesn't match your completely different starting assumption. If you reject the starting assumption then you are absolutely right, there will be a different appropriate response. I'm also a little worried about your statement that company valuations are "always overvalued". If that is your belief, then doesn't it follow that valuations are irrelevant and so I'm wondering why you are even interested in how valuations should or shouldn't be calculated? Finally, I'm pretty sure that most of your arguments are covered by my closing statement.
Great article. The elephant in the room is an enormous debt bubble which central banks and governments have created and are now trying to further increase. As a result of poor policy and short-termism, economies have been gradually becoming less productive than they would be if governments were less interventionist and had better policies. Economies (and many companies) are now less capable - or completely incapable - of paying back much of this increasing debt burden on their own . The likelihood of the debts having to be defaulted on in some way - either through a deflationary collapse or outright inflation and monetary debasement - is massive, and only increasing with time as the debt burden increases. Neither a deflationary collapse (including of asset prices such as housing) or high inflation is good for equity valuations (and as mentioned both are increasing in probability, which is not considered in most peoples' DCFs). In other words, lower interest rates can only be good ceteris paribus. They're not.
Finally, a pragmatic, well-argued, dispassionate analysis of the facts, as distinct from the hype. Thank you, Damien. It has become increasingly frustrating to read fallacious articles that argue for investment in equities simply because interest rates are low; 'Where else are you going to invest??' Well, I'd rather put my money in the Bank of Sealy than buy over-valued equities!
Great article Damien
Great content & well structured arguments