As an exceedingly good year for stocks comes to an end, the chat of currency markets bubbles fills the fresh air. Standard Pricing Metrics: In the attention of the beholder? Most of the arguments about whether we are in bubble place still are designed around the typical metrics, where equity multiples are compared across time and markets. In fact, a surprisingly large numbers of arguments, pro and con, derive from the PE ratio, with variants on earnings used by each relative side to make its case. Those that remain optimistic about the market focus on trailing or forward earnings and remember that the trailing and forward PEs, while high can be explained by low interest rates.
Like every other investment, the worthiness of a market depends upon cash flows, development (level and quality) and risk in stocks. Consider an investor who purchases the equity index. That investor can lay to state to all or any cash paid out by the ongoing companies in the index, composed of both stock and dividends buybacks.
Holding everything else constant, higher base-year cash flows and higher growth rates lead to raised beliefs for equities, whereas higher risk free rates and equity risk premiums lead to lower values for equities. Given these drivers of equities, where do we stand right now? The S&P 500 starts the year (2014) at 1848.36, up almost 30% from it’s degree of 1426.19, year prior a. Are we in a bubble?
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One way to evaluate whether stocks and shares are collectively misplaced is to compare the implied collateral risk superior today from what you think is a reasonable value. That “reasonable value” is obviously up for conversation but to provide some perspective, I have reproduced the implied collateral risk premiums for the S&P 500 from 1961 to 2013 in the figure below. The assessment of the equity risk premium above is a function of the risk free rate and my quotes of expected cash flows and growth.
Since all of these can and can change over 2014, it is advisable to judge which of these variables pose the best threat to collateral traders. While there are numerous who attribute the reduced rates within the last few years mainly through quantitative easing by central banking institutions, I remain a believe and skeptic that low economic growth was a much bigger contributor.
In fact, as economic development rebounded in 2013, interest rates rose, and if goals of continued development in 2014 come to fruition, I think that rates will continue steadily to risk, regardless of what the Fed decides to do. While that rise in rates might seem like an unmitigated negative for stocks, the net influence on stocks is a function of if the economic development also translates into higher revenue/cash flow growth. It is only when rates of interest rise at a much steeper rate than revenue growth rates improves that stocks will be hurt.
While the collateral risk premium today is not low, in accordance with historic criteria, the last five years have taught us that market crises can render historic norms useless. If, in truth, we noticed a reversal to the 6 back.4% equity risk premiums that people observed following the crash, the index would be valued at 1418, which makes it over valued by about 30% today. It really is clear that US companies returned to their pre-crisis buyback behavior in 2013 and there are some who wonder whether these cash flows are sustainable. To answer that relevant question, we viewed dividends and buybacks from 2001 to 2013 in the body below, each year and compare them to the earnings on the index.