March 1, 2021
Considerable uncertainty remains about the health of the economy in 2021. The Federal Reserve is not expected to raise interest rates until inflation returns unambiguously, for which there is not yet much indication. At her confirmation hearing for Treasury Secretary, Janet Yellen suggested that tax increases on corporations and the wealthy would likely be deferred until the economy recovers further from the pandemic.
Why then are stock market indices setting new records?
For the large-cap stocks, prices are high not only in absolute terms, but also relative to earnings. The price-to-earnings ratio is a measure of what investors are willing to pay for the future stream of earnings from a share of stock. As 2021 began, investors were willing to pay quite a lot indeed.
Yale Professor Robert Shiller popularized the cyclically adjusted price-to-earnings ratio (CAPE ratio), which smoothes the earnings data over ten-year periods. The graph below plots the CAPE ratio over time with long-term interest rates. A peak of 32.56 in the CAPE ratio was reached in 1929, before the stock market crash that led to the Great Depression. The ratio stayed below 25 throughout the prosperity of the post-War period, until 1996. It rose sharply at the end of the century, spawning the term “irrational exuberance” and topping out at 44.20 in 1999. Then came the dot-com crash.
In more recent times, the ratio reached 33.31 in 2018, responding perhaps to the corporate tax reforms enacted at the close of 2017. It fell to 24.82 in 2020 during the pandemic, before recovering to 33.74 at the start of 2021.
What accounts for the surprising investor optimism?
As the graph shows, part of the answer is that low interest rates make bond investing relatively less attractive. When interest rates were very high in the 1970s, the CAPE ratio fell to low levels. Regular double-digit payouts were more enticing than the uncertainty of dividend distributions. Today’s low interest rates have the opposite effect.
Another element may be a “flight to quality”—investors may believe that only the largest companies will have the resources to emerge successfully from the pandemic. Finally, investors may be looking ahead to a period when the pandemic is fully contained and the economy returns to robust growth. An increase in earnings brings down the CAPE ratio to more historically normal levels.
The answer to the headline question is that no one really knows how high stocks can go. But in uncertain times such as these, investors may benefit from professional investment counsel, such as we offer.
