Stocks, Fundamentals and Valuations——An Austrian Framework


Stocks and Interest Rates

How important are macro-economic fundamental data and valuations in deciding on whether or not to buy stocks, and how does this influence long term returns? Are there any universally valid rules that can be applied? At the very least we can state that there is plenty of empirical evidence that supports certain conclusions.

Mish has just posted a review of a recent weekly market comment by John Hussman, who probably writes more about market valuations than anyone else we know of. One of the most interesting aspects Mr. Hussman’s discusses in his missives on the topic in our opinion concerns the connection between stock market trends and interest rates, or what we might term his “empirical debunking of the Fed model”.


400Photo credit: Issei Kato / Reuters



To be sure, interest rates are an important determinant in the valuation of capital and future earnings streams. Given that stocks are titles to capital, it can be posited that ceteris paribus, low and/or declining real interest rates will tend to increase their prices, while high and/or rising real interest rates will tend to do the opposite. It is important to keep in mind that real rather than nominal rates are decisive here. As Mises once pointed out, the 90% discount rate charged by Germany’s Reichsbank in 1923 certainly looked very high in nominal terms – but in real terms it was ridiculously low.

So why does the empirical record show that there can be severe bear markets even while interest rates are extremely low or declining? The answer is that economic history is an amalgam of contingent circumstances – interest rates are just one piece of the puzzle. Investors or speculators cannot base their decisions on economic theory alone. In fact, a great many successful speculators know very little about economic theory, and most theorists know little about successful speculation.

An investor or speculator is, to paraphrase Mises, “a historian of the future”. He has to attempt to foresee above mentioned contingent circumstances as well, not only the trend of interest rates. When the financial crisis broke out in 2007-2008, central banks were furiously slashing their administered interest rates and started outright money printing on a massive scale in the final quarter of 2008. And yet, stock markets collapsed anyway. There is no need to recount why they collapsed – most people are well aware of the factors that triggered the plunge. The only point we want to make is that the market was overwhelmed by data that were considered far more important at the time than the interest rate cuts provided by the world’s central planners.

Japan’s stock market has largely ignored all time lows in interest rates for more than 20 years. Anyone buying the Nikkei in 1986-1989 based on the knowledge that call money rates would be close to, or at zero for most of the time between the mid 1990s to today would still be nursing nominal losses ranging from 30 to 50% – in spite of the Nikkei having risen about 150% from its 2009 lows by now.


1-Nikkei and RatesThe Nikkei Index and overnight interbank lending rates – never has the Fed model failed more spectacularly – click to enlarge.


Other Fundamental Data

How important are fundamentals in determining future stock prices? Fundamentals include both micro- and macro-economic data, which are of course not independent of each other. A company’s net asset value, indebtedness, earnings and expected earnings growth rates are useful in judging whether a stock represents good value, but it would be foolish to disregard the macro-economic backdrop. If the said backdrop turns hostile, it often matters little whether a stock represents value in terms of objective criteria (we are of course aware that all value judgments are subjective, but e.g. a price/earnings ratio is as such an objective datum that can be compared with the history of such data).

Often current or recent data fail to affect the direction of stock prices, simply because market participants expect them to improve or deteriorate in the future. Very weak macro data can also be ignored – such as is the case at the moment – if market participants expect the economy to be inundated with wave after wave of central bank-directed monetary inflation.

An especially egregious example of this is Venezuela. Its economy is a complete mess; it is so bad that there have regularly been shortages of the most basic goods, such as e.g. toilet paper (see “The Hygienically Challenged Crack-Up Boom” for some details on this particular problem). Anyone who believes that stock market trends provide information about the economy’s health would be stumped, as Venezuela’s stock market has been one of the strongest in the world over the past several years. It simply reflects contingent circumstances that are more powerful drivers than the pitiful state of the economy. Venezuelans are trying to safeguard their savings against the depredations of the country’s central bank, and capital flight is not an option for many, due to capital controls combined with completely unrealistic exchange rate pegs. The choices are limited and the stock market represents one of those.


2-IBVCThe Caracas IBC General Index: From 6 points in 2002 to 5620 points today. This is an advance of 93,567%. Over the same span, the socialist governments of Huge Chavez and Nicolas Maduro have ruined the country’s economy – click to enlarge.


Another example that shows that what are normally considered quite important fundamental data can fail to have the expected effect is the bear market in US stocks between January 1973 to December 1974. In this time period, aggregate S&P 500 earnings rose every single quarter. And yet, the market suffered what was then the worst bear market since the Great Depression. What caused this seeming disconnect? The lagged effect of the monetary inflation pursued over the preceding decades gravely impacted consumer prices and bond markets in the wake of Nixon’s gold default. Investors were aware of the rise in earnings, but they were discounting them ever more severely in light of surging CPI and soaring bond yields. This was exacerbated further in 1974 by the political crisis surrounding the Nixon administration coming to a head.

Over the long term, economic fundamentals are certainly important in determining whether stocks will deliver a positive return in real terms (note that the rally in Venezuela’s market must be put into context with the plunge in the value of the country’s currency). In the short term, investors’ appraisal of the future can easily lead to market behavior that is sharply at odds with what present fundamental data would suggest.

All of this buttresses the point made by Ludwig von Mises we mentioned above: investors must approach the market from a thymological perspective. Their task is to use their imagination and intuition to correctly perceive history that is yet to be written.


The Importance of Valuations

This brings us to our final point, namely the question of whether there is anything that can actually help with successfully navigating an environment characterized by so much uncertainty. This is where valuations come in. As such, valuations cannot tell one with certainty whether stocks (or other investment assets) will rise or fall over the coming months or even the next few years.

Under the assumption that monetary authorities won’t go completely crazy (this is to say, assuming that they will at least try to stick with their “price stability” mandate should consumer prices rise), valuations are however extremely important with respect to long term investment success. Obviously this applies both to buying and selling decisions.

It can easily happen that one sells stocks that look historically overvalued only to see them surge dramatically for a while yet (an example would be outlier events such as the technology mania of the late 90s), or that one buys stocks that look historically cheap, and yet they fail to rise for quite some time. However, a favorable long term outcome can invariably be expected. We refer you to John Hussman’s empirical work on the topic (which can be found in many of his weekly commentaries and research papers), which clearly shows the importance of valuations as a long term driver of stock market returns.

Funny enough, although this boils down to nothing more than the old truism “buy low, sell high”, only very few people are actually doing it. The reason for this is that low stock market valuations very often coincide with a terrible, often quite frightening, macro-economic environment. All the news headlines will be bad when stocks are actually cheap. Recent examples are provided by the 2008 crisis, the Russian market and the ruble, as well as Japan in the 18 months after the tsunami disaster. At the best buy point for US stocks in the 2007 to 2009 decline in early March of 2009, the daily sentiment index (DSI) stood at just 3% bulls. Seemingly no-one cared that many stocks had become ridiculously cheap.

Conversely, the future will usually look bright when stocks are very expensive and news headlines will tend to be comforting and supportive of a positive view of the market.

When the ruble fell prey to a wave of panic selling in December last year, with Russian stocks trading at a market-wide P/E ratio of less than 5, all the news headlines were screaming “don’t touch any of this stuff”. Mainstream financial media sites were chock-full with articles calling the Russian stock market a “value trap” and predicting a severe economic crisis for Russia. Little effort was made to actually look at Russia’s fundamental backdrop in more detail – this is to say, beyond the problems created by the Ukraine crisis and falling oil prices (we did make the effort, but we have seen no evidence of this in the mainstream media). To our knowledge, almost no-one delivered a rational assessment of the ruble’s decline and pointed out that a buying opportunity may soon be at hand.


3-RubleCurrently the ruble looks ripe for a short term correction, but the medium term trend has probably changed for good (the usual caveats apply; if e.g. the ruble were to violate the secondary low depicted above in a correction, our assessment of the situation would change) – click to enlarge.


Naturally, such situations always involve risk, but it can be minimized by being aware of how similar opportunities have played out historically (we actually delivered a step-by-step assessment of the ruble situation beginning on the day it hit its low: “The Russian Rubble”, “The Ruble Rebounds” and “The Forgotten Ruble”). It wasn’t especially difficult to analyze the situation – and we were very lucky in terms of timing in this case. The difficulty is in acting on the information. This is psychologically always very hard to do, as there are usually a thousand reasons for refraining from taking the plunge.

In Japan’s case, we were struck by the fact that valuations were very low and that sentiment was in the gutter. Once again, the market was widely hated all around. In this case our post on the topic was also fortuitously timed (see “Reconsidering Japan” from November 2012), but we were personally investing in Japanese stocks in dribs and drabs for quite some time already, so we can certainly not claim to have caught the timing of the market low with anything approaching precision – not to mention that we didn’t expect that Japan’s market would rise because an utterly reckless central banker would be appointed to head the BoJ and begin an unprecedented debt monetization orgy (we did however employ a currency hedge anyway).

The point we want to make in this context is actually this: Even if a cheap market one buys into does nothing for three years, if it rises subsequently by 150% in a span of two years, it will have been worth having exercised the required patience. The average annual return over the entire 5 year investment horizon is clearly more than respectable.

The very same considerations obviously apply when one is faced with an extremely overvalued market. Someone who sold technology stocks in late 1999 when the Nasdaq Index first hit 3,000 points (at which point they were already egregiously overvalued) had to watch in amazement when the index soared to more than 5,000 points in just a few months. And yet, it was the correct decision – or at least, a trailing stop would have been. It was impossible to foresee the sheer size and speed of the blow-off, but it was possible to discern that a state of unprecedented overvaluation existed.

Given that the Nasdaq subsequently plunged by 80% from its high (the NDX fell even further) in spite of the survivor bias built into cap-weighted indexes, there was plenty of opportunity to pick up technology stocks at rather more reasonable prices two years or so later.


4-NDXThe spectacular speculative blow-off and subsequent collapse in the NDX 1998 to 2002, weekly – click to enlarge.


We should interpose here that we are differentiating between medium to long term investment and short term oriented speculation. Both have their place and we are definitely not condemning speculation – on the contrary, we are defending it at every opportunity as an importance facet of the market economy. However, valuations are obviously only of secondary importance for short term speculators. Long term investors by constrast need to be very conscious of valuations.


Do Valuations Still Matter?

Currently there is a widespread conviction that valuations no longer matter, given that interest rates are pegged at or close to zero, and given that major central banks are alternating in “money printing duties” these days, seemingly one-upping each other with ever larger debt monetization and asset purchase programs. This line of argument actually rings true to some extent; as we always stress, monetary inflation is surely the most important factor driving asset prices these days. Investors have become quite reckless, as the recent surge in margin debt to a new all time high underscores.


5-Margin debtNYSE margin debt soars to a new all time high. Investors now have record negative cash balances   – click to enlarge.


However, there are many contingent situations conceivable when it will no longer be true: if for instance the damage done to the economy’s pool of real funding becomes so severe that the real economy falls prey to a major bust; if contrary to expectations, “price inflation” makes a comeback; if the euro area’s debt crisis flares up again; if China’s economy suffers a severe bust; if the BoJ loses control over the bond market and the yen, and so forth.

There is also no guarantee in which specific markets excess liquidity will be deployed. At the moment, stocks and bonds are at the top of the list, but this could easily change. Lastly, at some point valuations might become so utterly divorced from underlying fundamentals that a critical mass of investors could decide to cash in their chips simply because they can no longer imagine that the pool of “greater fools” will keep growing. The idea that “valuations no longer matter” is almost certain to be proved wrong over a long term investment horizon.


central bankersThe bureaucrats currently at the helm of the world’s major central banks: Janet Yellen, Mario Draghi, Haruhiko Kuroda and Mark Carney (the PBoC governor is missing in this picture, but he actually belongs there as well). Financial market participants have an irrational faith that these people won’t turn out to have been completely clueless this time around. However, they will. As we have previously discussed, no matter how well educated and well informed they are, they are all subject to the limitations imposed by the socialist calculation problem.



Based on experience and market history, our conclusion is that valuations are one of the most important, if not the most important, factor determining long term investment success. Over time, the views of market participants as to what represents low and high valuations has shifted somewhat. This is probably due to the long term downtrend in interest rates, the enormous growth of the global credit bubble and the concomitant increase of the money supply in most major currency areas.

However, even if an upward shift in the “historical valuation channel” has occurred, one should still heed the message when extreme valuations are reached. Overvalued markets will usually trade at lower prices and valuations at some point in the future, and the opposite applies to undervalued markets. An investment discipline based on valuations often involves “missing out” on some gains, and/or requires exercising a great deal of patience, but it will almost always pay off.


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