Friday's Market Minute: Making Sense Of Stocks Hitting New Highs

Many investors have been puzzled that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic and the economic downturn; especially in the United States, which has recently been setting record highs for new cases. However, with interest rates low and likely to remain depressed, equities will continue to look attractive, particularly when compared to fixed-income alternatives.

Asset markets are just as driven by psychology and narratives as they are by financial fundamentals. For example, there is the V-shaped recovery narrative and the FOMO (fear of missing out) narrative, both of which might be helping to drive markets to new highs. There is also the work-from-home narrative, which has specifically benefited technology and communication stocks.

Narratives aside, there are several ways to evaluate broad market financial valuations over time, one of which is the cyclically-adjusted price-to-earnings (CAPE) ratio, which captures the ratio of the real (inflation-adjusted) share price to the ten-year average of real earnings per share. When the CAPE ratio is high, long-term returns tend to be low over the next ten years, and vice-versa. Since the COVID-19 shock, CAPE ratios have mostly recovered to their pre-pandemic levels.

For example, the U.S. CAPE ratio in November 2020 is 33, exceeding its level prior to the start of the COVID-19 pandemic. In fact, it is now back to the same level as the high of 33 in January 2018. There are only two other periods when the CAPE ratio in the U.S. was above 30: the late 1920s and the early 2000s.

Does this mean the market is reaching a tipping point? Not necessarily, because one must observationally consider the potential role of low-interest rates in pushing up CAPE ratios. In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases and the price of the equity asset should appreciate, assuming all other model inputs stay constant. So, low-interest rate maintenance by central banks may be used to justify higher equity prices despite historically high CAPE ratios.

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