Stocks Are Allowed To Be Expensive Since Bonds Yields Are Low…Right? | #289

Episode Summary

Executive Summary: The episode argues that the popular claim "stocks can stay expensive because bond yields are low" is incomplete. Using long-run valuation data, Meb Faber shows that low rates alone do not justify high equity valuations or guarantee strong future returns; starting valuations, dividend yields, earnings growth, and inflation matter far more. His conclusion: U.S. stocks look expensive and likely to deliver low real returns, while foreign markets appear cheaper and more attractive.

Main Topics: Challenging the “low rates justify high valuations” refrain (Priority: 5/5): The host tests the common belief that low interest rates make expensive stock valuations acceptable, and argues the claim is often repeated without examining long-term evidence or future returns. Historical relationship between bond yields, inflation, and stock valuations (Priority: 5/5): Using CAPE and dividend yield data, the episode shows that high stock valuations historically did not coincide with unusually low bond yields, and low bond yield regimes often had average or below-average valuations. Valuations matter more than rates for future returns (Priority: 5/5): The key point is that low bond yields can coincide with strong future stock returns only when starting valuations and dividend yields are favorable; low rates alone are not the driver. U.S. vs foreign equity starting conditions (Priority: 4/5): The U.S. is described as historically expensive with low dividend yields, while foreign developed and emerging markets have lower valuations and better prospective return profiles. What drives long-term equity outcomes (Priority: 4/5): Future returns are framed as a combination of starting dividend yield, earnings growth, and valuation change, echoing a Bogle-style decomposition of equity returns. Portfolio implications and risk management (Priority: 4/5): The episode recommends resetting return expectations, rebalancing, considering global diversification, and potentially using tilts or alternative strategies such as trend following or real assets.

Key Arguments: The claim that stocks are expensive only because rates are low is historically weak; high valuations have not generally occurred during the lowest bond-yield periods. Low bond yields can be associated with strong future stock returns, but that relationship is largely explained by low starting valuations and high dividend yields, not low rates by themselves. When valuations are stripped out, low-rate environments are not especially favorable or unfavorable for future stock returns. Inflation matters because investors pay less for equities when inflation rises; low inflation helps valuations, but does not create unlimited upside. U.S. stocks currently start from unusually high valuations and low dividends, implying subdued long-term real returns. Foreign markets have more attractive starting valuations and dividend yields, so they may offer better future expected returns than U.S. equities. Investors should not extrapolate recent U.S. outperformance; mean reversion in valuation multiples can dominate long-term outcomes. A realistic base case for U.S. stocks over the next decade is low single-digit real returns, unless there is a major innovation-driven earnings acceleration or further valuation expansion.

Data Points: Current U.S. CAPE ratio: Around 36 - Described as the second-highest in history, behind only the internet bubble Historical U.S. CAPE average: Around 17 - Long-run historical average for U.S. stock valuations Historical 40-year U.S. CAPE average: Around 22 - Referenced as closer to current foreign developed markets Internet bubble CAPE peak: Almost 45 - Highest U.S. valuation cited in the analysis Japan 1989 CAPE peak: Around 95 to 100 - Presented as the highest valuation ever recorded in any stock market Top 10% of stock valuations: CAPE over 25 - Average bond yield during these periods was cited as 5.1% Top 30% of stock valuations: CAPE over 30 - Average bond yield during these periods was cited as 5.5% Lowest quintile of bond yields: Average CAPE around 13 - Shows low yields historically coincided with below-average valuations Inflation threshold for valuation rerating: Below 4% inflation roughly doubles CAPE from about 10 to about 20 - Illustrates that tame inflation supports higher multiples Average future real stock return: About 6.5% - Used as a benchmark when comparing low-yield regimes Lowest quintile of bond yields and future real stock returns: About 10% real stock returns over the next 10 years - Nominal low-rate regime appears favorable in isolation Lowest quintile of real bond yields and future real stock returns: About 11% real stock returns - Even stronger when measured in real terms Starting CAPE in low-yield/high-return periods: About 13 CAPE and 5.4% dividend yield - Shows favorable future returns coincided with cheaper entry valuations Starting CAPE in low real-yield/high-return periods: About 11 CAPE and 5.4% dividend yield - Similar pattern for real yields Ending CAPE in those favorable periods: About 18 CAPE - Valuation expansion contributed materially to returns Best stock-return quintile: About 14% real returns over a decade - Average outcome for the strongest historical 10-year return periods Worst stock-return quintile: About -1% real returns over a decade - Average outcome for the weakest historical 10-year return periods U.S. stock expected real return base case: 0% to 2% - Host’s estimate for the next 10 years Required valuation multiple for 10% annual returns: Roughly back to 1999 peak multiples - Illustrates how ambitious expectations are if returns are to reach 10% Required valuation multiple for 15% annual returns: Japan 1980s-level multiples - Used to show how implausible very high return forecasts are Foreign developed market CAPE: Around 22 - Presented as more attractive than the U.S. starting point Foreign emerging market CAPE: Around 15 - Cheaper than developed markets and far cheaper than the U.S. Cheapest countries’ CAPE: Around 12 - Highlighted as the lowest-valuation opportunities Typical U.S. investor stock allocation: About 80% in U.S. stocks - Described as a large overweight to the most expensive market U.S. share of global GDP: About 25% - Used to argue for more global diversification Value exposure in emerging markets for Americans: About 3% allocation - Presented as very small relative to attractiveness of valuations Startup investments held by host: Over 230 startups - Used to illustrate belief in innovation as a possible upside case

Pivotal Quotes: "“high stock valuations are fine since interest rates are low.”" — Meb Faber: The common market refrain the episode is designed to test and challenge "“You cannot find a valuation indicator that says stocks are cheap right now. They all say they're expensive.”" — Meb Faber: Summary judgment on current U.S. equity valuations "“The good times often fall the bad times in markets and economies. And vice versa.”" — Meb Faber: Core framing for mean reversion and cyclical market behavior

Implications: Listeners should lower U.S. return expectations, diversify globally, and avoid assuming low rates justify expensive equities. Future outcomes are likely to hinge on valuation mean reversion, earnings growth, and inflation rather than rates alone.