This time is different — NOT
(This article was written on May 9,2017. It remains highly relevant)
When one of the world’s most acclaimed value investor dares to utter the words, ‘this time, it’s different’, we must sit up and take notice. Either it is a sign of a market top because one of the long-standing value investor had capitulated or that there is more upside left now that even value investors have acknowledged that it could be different this time.
Jeremy Grantham was a co-founder of GMO that bears his name. In his most recent quarterly investment newsletter (available to all after a simple registration at the site, www.gmo.com), he had pointed out that the interest rates — short and long — have been meaningfully lower in the last twenty years than before. Profit margin and profit share of GDP have been meaningfully higher. Therefore, the average Price-Earnings (P/E) Multiple has been higher in the last twenty years than before. In other words, the benchmark to compare the current market P/E is not the historical norm of 14 or 15 times but the ‘new normal’, which is around 24 times.
It is a sign of his intellectual openness at this age and after cutting his teeth in several bear markets that he is able to contemplate the possibility that his model might no longer be relevant and that the world had changed. My response that follows does not prove him wrong and me correct. Both of us do not know how it would play out. However, contemplating a challenge to his hypothesis would enrich our understanding of the risks and rewards in the U.S. stock market at this juncture.
What is the ‘new paradigm’?
There is a problem with this analysis. The unsustainability of the price-earnings ratio stems from the unsustainability of the profit margin. In turn, it stems from the unsustainability of the model of capitalism, of division of surplus between capital and labour and of the monetary policy framework. Profit margins have been high because interest rates have been low. Interest rates have been low because inflation rates have been low. Inflation has been low because wage growth has been slow. Wage growth has been slow because the global pool of labour helped keep wages low and workers insecure. Instead of wage growth, American middle-class and low-income families were served the aphrodisiac of credit (sub-prime mortgages). The result is that more than half of the surveyed American families do not have even USD500.00 in their savings accounts to cover emergency expenses. If this model were deemed sustainable, then yes, the U.S. equity market is on a sustainable footing and that one could confidently predict several more years of double-digit returns for U.S. stocks.
Political consequences of the ‘new paradigm’
At a political level, this model has not proven sustainable. That is why we have had the election deliver an unexpected (for the elites, that is) result in the United States. That is why most Britons opted to leave the European Union. That is why Bernie Sanders came close to clinching the Democratic Party nomination in the United States Presidential elections. That is why James Corbyn became the leader of the Labour Party in the United Kingdom. That is why a radical political party gained vote share in the Netherlands. That is why a Marxist candidate drew nearly 20% votes in the first round of Presidential elections in France in April. Clearly, from the political side, Mr. Grantham has his answers. This time is not different.
Federal Reserve is behind the new valuation paradigm
While Mr. Grantham has five charts in his little note, I would reproduce just one here (chart 1) to argue that it is largely due to the monetary policy conduct of the Federal Reserve.
Chart 1: Stocks no longer become cheap
Source: See end note 1
This chart shows that in the first two of the four circles, the Price-Earnings Multiple of S&P 500 spent a long time well below the mean P/E level. Shiller P/E bottomed out in single digits on both occasions. In the stock market bust of the year 2000, it did not come below the mean at all. After the 2008 crisis, it briefly dipped below the average but bounced back rather quickly. What has changed? A principal reason is the monetary policy of the Federal Reserve. It is not clear to me if Mr. Grantham had read this seminal paper, ‘Stock returns over the FOMC cycle’. However, the conclusions from that paper are damning of the Federal Reserve and provide solid evidence that the temptation to declare that this time could be different should be resisted. These are the conclusions:
“In particular, of the 191 percentage points of cumulative log stock returns since 1994, not only has all of it been earned in even weeks, but the majority (157 percentage points) has been earned on just 531 even-week Fed put days, i.e., days when the market is in the lowest quintile of performance over the past week, month, and quarter. Had it not been for the returns on these 531 “Fed put” days — accounting for less than 10 percent of all days over the 1994–2015 period — $1 invested at the start of this period would have grown to only $1.40 (exp(1.91–1.57)) as opposed to the actual value of $6.75 (exp(1.91)). Furthermore, low stock returns are an economically and statistically strong predictor of reductions in the federal funds target rate.”
The authors go on to indicate an even stronger indictment of the Federal Reserve monetary policy than mere interest rate support to financial markets:
“We argue that a more plausible channel for information getting to asset markets is systematic informal communication of the Fed with the media and the financial sector.”
As I was writing this, I chanced upon a more recent paper by two of the authors of the earlier paper (see footnote 3) on the Fed ‘Put’. Their conclusions are equally revealing. From around the mid-1990s, the Federal Reserve had begun to pay much greater attention to stock market performance between meetings. They confirm that a negative stock market performance has predictive power for rate cuts. There is not much reaction to positive stock market performance! In other words, the Federal Reserve does not tighten in response to positive stock market returns.
Further, the Federal Reserve updates its expectations for macro variables based on stock market performance. Its update to its macro-economic forecasts is sizeable and statistically significant for negative intermeeting excess stock returns but its updates were small and insignificant to positive return realisations. More interestingly, before 1994 and going back up to 1982, there was no significant relationship between the stock market and updates to Fed growth expectations. It appears that the Federal Reserve had become more sensitive to the perceived or feared impact of the stock market returns on macro variables than was necessary. In other words, in reality, macro-economic variables are not that sensitive to the stock market as the Federal Reserve thinks. That is the crucial part of the paper.
Here are the key findings:
(1) Reaction of actual economic output (GDP growth) to excess stock market returns is small and is symmetric for stock market gains and losses.
(2) Reaction of unemployment to excess stock market returns is asymmetric. That is, unemployment rises more when stock market records losses than it falls when the stock market posts gains. But, the Federal Reserve expectations for unemployment change much more than actual unemployment changes themselves!
(3) Sensitivity of actual private consumption to negative stock market outcomes is small, especially in the 1994–2016 period. But, the focus of the Federal Reserve on the stock market is driven a lot by its concern over stock market declines on consumption.
(4) The Fed updates its macroeconomic expectations (about growth and unemployment) in a way that is highly sensitive to stock market outcomes during the inter-meeting period. This relationship is pervasive starting from the mid-1990s, but is largely absent before that.
It is clear that the sensitivity of the Federal Reserve monetary policy to stock price movements is excessive and almost unwarranted. Why did the Federal Reserve become more sensitive to the stock market in the last two decades? We can only guess. Political economy explanations would be dubbed conspiracy theories. But, ‘capture’ — intellectual or otherwise — cannot be ruled out. Mr. Rubin formally became the Treasury Secretary in January 1995. He was from the Goldman Sachs. Intellectually, he might have convinced the Federal Reserve that the stock market mattered to the health of the American economy. Mr. Greenspan raised the Federal funds rate by 300 basis points in 1994–95. He faced criticism for doing so. He was also criticised for musing aloud if the stock market could be irrationally exuberant. Perhaps, those criticisms persuaded him to change 180 degrees from a sceptic to a cheerleader. More charitably, the Federal Reserve might have become more sensitive about the stock market because stock ownership in the U.S. economy might have become much more pervasive in the Nineties. We can only guess.
Capitalists won; labour lost
While we assign a big role to the Federal Reserve in the dynamics of profits and margins that drove stock prices in the last two decades, we should also recognise that profit share of value added rose at the expense of labour. It was as much due to technology and globalisation of labour supply as it was due to policy and political choices made by American governments over the years. More importantly, it was not just a phenomenon confined to the United States. It happened in several advanced nations and even in developing countries. Labour market institutions had either atrophied or have been weakened as capitalism advanced.
The increase in the capital share of GDP has not correspondingly increased investment in real assets. If that happened, it would have helped employment generation and would have moderated the decline in wage share. Much of the increase in capital share went towards executive compensation in the form of stock and stock option grants.
The charts below (Charts 2 and 3) tell the story more vividly than pages of text could do.
Chart 2: Declining labour share of national income
Source: The Labour Share in G20 Economies, International Labour Organization and Organisation for Economic Co-operation and Development with contributions from International Monetary Fund and World Bank Group, report prepared for the G20 Employment Working Group Antalya, Turkey, 26–27 February 2015
Chart 3: Wage rise slower than productivity growth
Source: see chart 2
Accident waiting to happen
Our final message is that U.S. stocks are an accident waiting to happen. The longer it is delayed, the bigger it will be and the bigger the impact on the rest of the world too. Whether we are right or not, we will not know. But, we think that Mr. Grantham’s musings are also, in a way, a sign of market top. Second, the fact that four times leveraged exchange traded funds are being launched now after the market has run up so much and after eight years since the last recession is also a confirmation that the market advance is in its terminal stage. Third, commentators like Mr. Grantham note the absence of panic buying. Well, to a degree, the frenzied inflows into the domestic stock funds in the last few months, bucking the trend of the previous two years is a sign of panic buying (chart 4).
Chart 4: Long-term equity fund and ETF net flows
Source: https://www.ici.org/info/combined_flows_data_2017.xls (May 3, 2017)
Lastly, VIX — volatility indicator of the stock market — has breached 10% and is lower than it had ever been. It traded at 9.77% on Monday. Even at the peak of the euphoria in 2007, volatility was not this low. The previous low was 9.89% on January 24, 2007. Investors are selling volatility even at these levels. We leave it to you to draw your own conclusions.
 An updated version of the paper can be downloaded from here: http://faculty.haas.berkeley.edu/vissing/cycle_paper_cieslak_morse_vissingjorgensen.pdf
 See Anne Cieslak and Annette Vissing-Jorgensen (2017): ‘The Economics of the Fed Put’, April 2017 (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2951402)