By the Swedish House of Finance, Sweden’s national research center in financial economics: NYU’s Sydney Ludvingson discusses drivers of equity value growth, the risks associated with high valuations and rising interest rates, and how policymakers and investors can mitigate those risks.
What are the key factors that have significantly influenced the rise in equity values since the post-war era?
“It is useful to take note of two striking patterns in the data over the post-war period.
The first is equity cash flows, or the earnings and profits generated by a company that are distributed to its shareholders as a return on their ownership. These payouts represent measures of fundamental value to the stock market. According to textbook theories, the stock market and the broader economy should share a common trend, implying that the same factors that boost economic growth, are also the key to rising equity values over longer periods of time.
Yet if we look at the post-war period, economic growth averaged only 2.6% per annum in the 1989-2017 period compared to 3.9% in 1966-1988, while the real value of market equity of the U.S. corporate sector grew at an average rate of 7.5% per annum over the 1989-2017 period, compared to only 1.6% over 1966-1988. Why? Despite lower growth, the 1989-2017 period exhibited growth in after-tax corporate profits of 5.1% per annum, far outpacing the 1.8% profit growth of 1966-1988.
This implies that there was a markedly higher profit share of output in 1989-2017 compared to 1966-1988. Our estimates suggest that these shifts in the share of rewards going to equity holders alone explain around 45% of the increase in equity values over the past 30 years.
The second striking pattern in the data is related to discount rates, which refer to the rate at which future cashflows, such as earnings or payouts, are adjusted or discounted to their present value. Changes in interest rates influence the short-rate component of the discount rate, which in turn can impact equity values.
We find that periods of accommodative monetary policy align with consistently high stock market valuations, while restrictive periods coincide with low valuations.
The 1978-2001 period was characterized by a restrictive monetary policy with low valuations. In 2006-2008, just before the Global Financial Crisis, also saw somewhat restrictive policy, but to a lesser extent. Most of the last 20 years and all of the last 15 years had accommodative regimes with high equity valuations.”
What are some of the risks associated with the level of equity values right now and how can policymakers and investors manage these risks?
“Valuations remain high by historical standards, even though markets declined about 20% last year.
This is because the run-up in equity values even in the last five years prior to these declines had been so rapid that stocks are still high relative to where they have been historically. Markets appear optimistic once more, rising at a healthy pace so far this year, even though they are still richly valued. As interest rates rise, there is a risk that markets will decline back toward more normal valuation levels.”
How can policymakers and investors manage these risks?
“Lower equity return premiums are associated with declines in the federal funds rate (FFR) due to policy regime change, while increases in the FFR from policy regime change are linked to higher equity return premiums. This relationship is found only for policy-driven changes rather than general movements in short rates.
This type of correlation can happen if markets/investors have a form of ‘fading memory’ of past policy rules. Once investors have spent enough time in a particular policy regime, memory of past policy rules fades, and they come to view the existing policy stance as the new normal. Investors extrapolate too much from the observed continuity in the policy stance, so that the perceived persistence of policy regime shifts overstates their true persistence. Fading memory of past policy rules means that investors overreact to policy shifts and are always surprised by the inevitable transition out of the existing policy regime.
The risk something like this would create for the Fed and other central banks currently is that markets/investors may have a harder time buying into the idea that the accommodative policy regime they had become accustomed to over the last 15-20 years has been replaced by a truly restrictive policy stance.
This is despite the ten nominal rate increases recently which, given the persistently higher inflation, have not led to very high real rates especially at the short end of the term structure, at least not yet. Due to the recent history of prolonged accommodative policy, markets may continue to price in the expectation of a quick pivot to lower rates if an adverse shock occurs, even if inflation remains stubbornly well above the central bank’s long-term objective of 2%. Markets may not fully believe the inflation-fighting resolve of central banks.
One could speculate that expectations of this form are partly why markets have risen healthily this year, despite the increased odds of a recession. To the extent that this creates additional inflationary pressure, which the Fed seems to worry about as a real possibility, this is not helpful to their objectives.
Managing these risks is likely going to involve persistent, clear communication, about the precise conditions under which investors should expect a rate cut and how central banks will credibly handle a conflict between the twin objectives embedded in their dual mandate, should those in fact become at odds with one another.”
How have policy makers been managing these risks so far?
“It is a tough line to walk, especially as central banks are also learning in real time.
You can see the efforts with communication by policymakers directed at markets. You can also see hints that markets are not very clear or convinced about how central banks will handle complications to their plans, such as a banking crisis, a default on U.S. debt, or a sharp downturn that creates stagflation.
Central banks could try to be even clearer on these aspects of their forecasts and plans, though this is admittedly challenging as it involves many contingencies and unknowns.”
How will changes in interest rates affect equity values in the years ahead?
“Although short rates are on their way up now, which all else equal would tend to put downward pressure on stocks, it really depends on how persistent investors believe those rate changes will be.
If investors believe these rate increases are likely to reverse soon, equity values may continue rising again. If they believe the Fed and other central banks will persist in keeping them higher for longer, in the event that inflation remains stubbornly high, equity valuations could stay where they are or even decline again. Only time will tell.”
Bio: Sydney Ludvigson is Julius Silver, Roslyn S. Silver, and Enid Silver Winslow Professor of Economics at New York University, and a Co-Director of the National Bureau of Economic Research Asset Pricing Program. Her research centers on the interplay between asset markets and macroeconomic activity, with applications to role of monetary policy in stock market fluctuations, the measurement and analysis of systematic and demonstrable errors in macroeconomic expectations by both professional forecasters households, the use of machine learning and AI algorithms to measure errors in human judgement, the pricing and risk premia of stock, bond, and housing markets, the role of heterogeneity and wealth inequality in housing and stock market valuations, and the dynamic causal effects of uncertainty for business cycle fluctuations.