Valuation Variety

Here by intervention
I want your attention
--Duran Duran

Liz Sonders writes that valuation methods are so subjective that at any time you can find some showing markets as undervalued while other metrics indicate overvaluation. Perhaps, but it is often the case that underlying assumptions cause metrics to diverge for predictable reasons.

The valuation metrics that Sonders presents help demonstrate. The first three metrics suggest that markets are cheap while the rest suggest that markets are expensive. What do the first three have in common? They all employ current interest rates as the discount rate for valuing stocks. As these pages have noted repeatedly, rates are at historic lows, driving discounting operations to render  'fair values' higher than they would be otherwise. Plugging in discount rates closer to long term average interest rates reduces fair values considerably, thereby reducing the 'undervalued' signal.

The other metrics on the list do not employ discount rates directly. Most of them reflect investor operations driven by low interest rate policies. One of these operation is known as TINA. In low interest rate regimes, investors buy stocks--particularly those with yield--because There Is No Alternative.

Low interest rates also encourage borrowing money to buy stocks, also known as the carry trade. Cheap sources of funds add to the amount of money in the market buying stocks, thereby bidding prices higher. Margin debt near all time highs provides a sense of the state of leveraged buying currently in effect. When that leverage comes off, prices will certainly feel downward pressure.

There is also, of course, the effect of non-economic buyers in the market, such as central banks and sovereign wealth funds, that are buying securities in part to complement low interest rate policies already in effect as a means to prop up markets and economic activity.

The message conveyed by different valuation methods may diverge in their message on the surface, but digging deeper suggests more convergence than meets the eye.