In Search of the Missing Metric
By Ben Stein
Special to TheStreet.com
12/12/2001 08:43 AM EST
Alert readers -- and I have plenty of them in this space -- will recall that two weeks ago I said I might have found a metric that would explain something about the startlingly high price-to-earnings ratios in the current stock market.
That metric, as you might imagine, is -- or was -- interest rates. In classical finance theory, still used by masters like Warren Buffett, a stock is worth the discounted present value of all of its future earnings. (Actually, in classic theory, stocks are worth the net present value of their dividends. This has obviously been discarded, as so few stocks besides preferred and utilities pay much of a dividend these days. And to some extent, a stock's undistributed profits can be realized simply by selling the stock.)
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If interest rates fall, and if the assumption is that they will stay low for a long time, the interest rate to be applied to discounting those future earnings falls. As it falls, the value of the net present sum of all future earnings rises. To take the crudest possible example, if the interest rate applied on a string of earnings for 50 years falls by half, the net present value rises by an amount that is not double, but approaches double.
This factor definitely had something to do with the startling rise in P/Es of stocks from 1990 to early 2000 and beyond. Long-term rates on corporates fell by nearly 40%. This should have greatly raised the P/Es of stocks, and, along with bubble thinking, it did.
But by definition, the fall in the interest rate on bonds should offer a rough comparison with the rise in the earnings yield on stocks. That is, the rate on stocks is supposed to have some rough congruence with the rate on bonds. This didn't happen, as bond yields remained well above stock yields through the bubble and beyond.
Reasons for the Rise
So why are stock prices so high right now? As everyone knows, Alan Greenspan and his Federal Reserve have been dramatically pushing down rates since the onset of the recession, and short-term rates have fallen fantastically. This is terrible news for savers, but alas, it has not been great news for borrowers, as medium and long rates have stayed stubbornly high.
Anyone seeking a mortgage today can see this in black and white. Short-term rates have fallen by more than half in a nine-month span, while mortgage interest rates are about where they were in the spring. They, along with bonds, are down about 15% while short-term rates have fallen by more than half.
Here's the rub. Yes, we have very low short-term rates. But we have high long-term rates considering the short-term rates and the economy's weakness. Long-term bonds are now, after the slightest whisper of recovery, approaching 7% for high-grade corporates. If we discount future earnings of stocks back to the present for earnings beyond a year or so, we must use that long-term rate -- and it has stayed high, in fact, incredibly high.
That is, if we were to say that stock yields and money-market yields should be equal, there would be room for a huge upward move in stocks. But this would be nonsense. The entire credit market is saying with one loud voice that rates will not stay low, that inflation will revive, and that they refuse to lend except on the basis of expectations of continued high interest rates.
Put another way, they're saying that stock yields have to be discounted at 7%, or certainly above 6%. So much for talk about deflation. So much for stock prices rising to reflect "low" interest rates. That metric I was hoping to find has evaporated in the past two weeks, if it ever was there at all.
Yellow Light for Yield Curve
But as I studied this subject (and bonds have always been a big interest of mine), I came across a worrisome sign. The yield curve is the steepest it has been since the Great Depression. Only in the Depression did interest rates start so low for short-term money and rise so fast for long-term bonds. In the worst of the Great Depression, when short-term money yielded less than 0.15%, long-term bonds were still yielding 4.5%.
In fact, the great geniuses Milton Friedman and Anna Jacobson Schwartz, in their must-read Monetary History of the United States, insist that these high rates, held up by the market's and the Fed's insane fears of inflation, prolonged the Great Depression because real rates (nominal minus inflation -- or deflation) were so high. If you think that prices were falling 5% or more per year from 1929 to 1933 and nominal rates were 4 1/2%, then that makes the real rate close to 10% in a time of depression.
Something eerily similar is happening now. The short end of the market in risk-free lending is below 2%. In fact, it's about 1.75% after Tuesday's Fed cut. At the long end, the rate is about 6%. This is a unique yield curve in the postwar era. It is undoubtedly hindering the recovery by making borrowing so pricey in a difficult environment. But it's also indicating that the bond boys are saying that you should be discounting stock earnings at a much higher rate than the stock market is saying.
I'm not in the business of predicting stock prices, but the bond market is telling us that a high interest rate environment is here to stay. That does occasionally say something about stocks once the bubble is gone -- and I'm not at all sure that it is. But someday it will be, and then perhaps historical analogies will mean something again.
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Benjamin J. Stein has been a trial lawyer, a White House speechwriter for former Presidents Nixon and Ford and a campaign speechwriter for Reagan. He has been a columnist for The Wall Street Journal and written for publications including Barron's, New York magazine and Los Angeles magazine. He is a novelist, a nonfiction book writer and a screenwriter, and he has been an expert witness on financial fraud. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. At time of publication, Stein had no position in any of the securities mentioned, although positions can change at any time. While Stein cannot provide investment advice or recommendations, he invites you to send your feedback to Ben Stein. |
