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Do record-low interest rates justify the stock market’s overvaluation? Here’s the answer

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The stock market is even more overvalued today than it was a month ago.

That was when I last reviewed the status of eight of the most widely followed valuation indicators. The table, below, summarizes these indicators’ latest readings and where they stand in a historical context.

Since most of these indicators a month ago were already indicating that the market was more overvalued than at any time in recent U.S. history, this month’s update hardly seems noteworthy. Equities have been overvalued for several years running, and yet the market averages keep on rising.

How boring, even if dangerous.

I’m therefore devoting this month’s valuation update — a regular feature in this space — to the most common comeback I get from readers when I report the market’s extreme overvaluation: If I only took interest rates into account, I’d discover that the market is not overvalued.

This is a convenient story for the bulls to tell themselves, since interest rates are at historically low levels. Unfortunately there is precious little historical support for it.

Consider what I found upon measuring the predictive power of each of these valuation indicators, calculating a statistic known as the r-squared (which ranges from a low of 0%, or no explanatory power, to 100%, or complete explanatory power). In each case I calculated the r-squared in two ways: Once when focusing on the indicator by itself, and then a second time in conjunction with prevailing interest rates.

It turns out that none of these indicators’ r-squareds significantly changed upon taking interest rates into account. To illustrate, consider the so-called Buffett Indicator, which is the ratio of the total market cap of the U.S. market divided by gross domestic product. Its r-squared is 47% when used to predict the S&P 500’s
SPX,
+0.25%

 10-year inflation-adjusted total return, which is higher than the r-squared of any of the other indicators in the table below.

When adjusting the Buffett Indicator by the real interest rate (the 10-year Treasury’s yield minus the CPI’s change over the last 12 months), its r-squared is essentially unchanged, at 48%. But that’s not even the half of it: In an econometric model that includes both the Buffett Indicator and real interest rates, lower rates are associated with lower subsequent 10-year returns — not higher.

Upon including just the Buffett Indicator in this econometric model, for example, the S&P 500’s projected 10-year inflation-adjusted total return is minus 9.3% annualized. Upon including real interest rates in the model, the projection worsens to minus 10.4%.

Are you surprised by this result? You shouldn’t be. Persistently low interest rates indicate that the markets expect future economic growth to be anemic at best. Far from celebrating what today’s low interest rates mean, the bulls should be worried.

Sleight of hand

How could the bulls be so wrong when arguing that low rates justify higher valuations? My hunch is that, either consciously or unwittingly, they are guilty of a sleight of hand. They in effect are confusing two very distinct historical tendencies:

• What happens to stock market valuation ratios as interest rates decline

• What is the stock market’s future return when interest rates are low

Notice that the first is referring to a coincident tendency while the second refers to a forward-looking tendency. Yes, valuation ratios tend to rise as interest rates fall. But that is entirely distinct from what happens in the years subsequent to when interest rates are already low.

Another way of appreciating this subtle point: In order to exploit the first tendency for market-timing purposes, you’d have to know where interest rates are headed. Good luck with that.

The bottom line? The stock market is overvalued, period. Far from allowing us to wriggle out from underneath the bearish weight of that overvaluation, today’s low interest rates add fuel to the fire.

Status of valuation indicators

The table below reports the latest values of the eight indicators I report each month in this space. For a full description of how each of the indicators is calculated, please refer to my Oct. 30 column.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.



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These money and investing tips can remind you to not take Mr. Market’s moods personally

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Don’t miss these top money and investing features:

These money and investing stories, popular with MarketWatch readers over the past week, help you make sense of your investment portfolio when stocks and bonds are choppy and Mr. Market’s mood seems to change hourly.

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Emerging market equities’ place in retirement portfolios

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How much should you allocate of your retirement portfolio to emerging market equities?

It’s a timely question, since many widely-followed Wall Street firms are telling their clients that emerging market stocks are the only equity category whose expected return over the next decade is above inflation. Perhaps the most prominent of such firms is GMO, the Boston-based investment firm co-founded by Jeremy Grantham. It is projecting that the emerging market equity category will beat inflation over the next seven years by 5.0% annualized. In contrast, the firm is forecasting a 6.2% annualized loss to inflation over the same period for the S&P 500
SPX,
+1.95%
.

As is also widely known, however, GMO has been making similar forecasts for many years now, and at least so far has been very wrong. Over the trailing 10 years, according to FactSet, the iShares MSCI Emerging Markets ETF
EEM,
+1.09%

  has produced a 3.4% annualized return, almost 10 annualized percentage points below the 13.3% annualized return of the SPDR S&P 500
SPY,
+1.84%
.

Fortunately for our purposes, Credit Suisse has just released the latest edition of its Global Investment Returns Yearbook, authored by finance professors Elroy Dimson, Paul Marsh, and Mike Staunton. This yearbook arguably is the most comprehensive database of global returns, as it reports performance since 1900 for “equities, bonds, cash, currencies and factors in 23 countries.” For the first time, furthermore, this year’s yearbook was “broadened to include 90 developed markets and emerging markets.”

This long-term perspective is especially crucial when assessing emerging markets. That’s because we can all too easily forget that many emerging stock markets disappeared altogether at various points since 1900 due to “major events such as revolutions, wars and crises.” Their losses need to be taken into account when judging emerging markets’ prospects, and this Yearbook does.

This long-term perspective is crucial for another reason as well: Some emerging markets over the last 121 years have performed so spectacularly that they graduated to the “developed” category. Index providers employ a complicated methodology for determining when that graduation takes place and, as you can imagine, a lot is riding on that determination. But the inevitable result is that some of these emerging markets’ spectacular performance gets credited to developed market benchmarks rather than to emerging market indices. This yearbook’s authors employ an elaborate methodology to place each market each year in the appropriate categories.

You may say you don’t care how a country’s stock market is classified, just so long as it performs well. But you should care. If you invest in emerging market equity index funds, you at least implicitly are relying on the decisions that index providers make about what counts as an emerging market. There’s no way around it.

Long-term performance

Without further ado, let me turn to what the Credit Suisse Yearbook reports. Over the last 121 years, emerging market equities have produced a 6.8% annualized return to a US-dollar investor, 1.6 percentage points below that of developed markets’ 8.4% annualized. I note in passing that developed market bonds beat emerging market bonds over this period by a similar magnitude: 4.9% annualized versus 2.7%. These returns are plotted in the accompanying chart.

These long-term returns suggest that the last decade’s results are not as unusual as they may otherwise seem.

Do these results mean that there’s no need to allocate any of your retirement portfolios to emerging market equities? Not necessarily. Part of the rationale for investing in them derives from their potential diversification benefits: If they zig while developed market equities zag, and vice versa, then a portfolio that invests in both would incur significantly lower volatility, or risk, than one that invests in developed market equities alone. This in turn could translate to superior risk-adjusted performance even if emerging market equities underperform.

The yearbook’s authors find that emerging market equities do provide some diversification benefit. However, that benefit has been declining over the last several decades, as correlations between their returns and those of developed markets have been rising.

The bottom line? I came away from this latest edition of the Credit Suisse Yearbook with diminished long-term expectations for emerging market equities.

That doesn’t mean we should automatically avoid them. But we should base any decision to invest in them on other factors besides their long-term returns.

GMO and the other firms advocating for emerging market equities do just that, by the way, basing their bullishness on valuation considerations. They believe that emerging market stocks are very cheap, according to any of number of valuation metrics, both in their own right and relative to developed market (and especially U.S.) stocks.

GMO and similar firms may very well be right, of course. But the 121-year record suggests that they will have to be very right indeed to overcome emerging market equities’ long-term tendency to lag developed market equities.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.



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‘I want to hurt him the same way he hurt me’: My husband sprung a prenup on me 3 days before our wedding. Now I’m starting my own business and want to amend it

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Dear Quentin,

I was married just over 2 years ago and I have been in the same relationship for more than 10 years. We have both been single parents from prior relationships. Considering our age gap, he is much more successful in life as a sole proprietor. He’s 56, and I’m 40. He talked about a pre-nuptial agreement during our relationship, but he did not spring it on my until 3 days prior to our wedding day.

We discussed nothing as to what would go into the agreement. I was severely depressed, cried uncontrollably for days. Even reliving this is causing heartache. I consulted with my attorney but decided to sign it rather than not go through with the wedding. For two years, I asked for a copy and he couldn’t find it: When I finally had enough, I found it in his office, and made myself a copy.


‘I’m angry at myself now because there are provisions I would have included had I had more time to think about it.’

I still don’t fully understand what happened, and I’m angry at myself now because there are provisions I would have included had I had more time to think about it. My parents will be willing me a home, and a nice considerable amount of cash. I’m not in his will, there is no life-insurance policy, and I’m not listed on the deed of the second vacation home “we” bought before we married, but he wants to say how everything is ours.

Technically, it isn’t. Now that I am about to start my own venture, which may be lucrative, potentially six figures a year, I want to amend the prenuptial agreement. In a way, I want to hurt him the same way he hurt me. It’s caused a lot of resentment on my end as I feel he never trusted me, although I have never asked him for anything. If he dies tomorrow, what is going to happen to me?

Should I amend the prenuptial agreement? Is it possible that the current prenuptial agreement is null and void?

Postnuptial State of Mind in Pennsylvania

You can email The Moneyist with any financial and ethical questions related to coronavirus at qfottrell@marketwatch.com

Dear Postnuptial,

You should know what’s in your own prenuptial agreement, given that’s it’s a legal document you both signed. I don’t understand why you did not have a copy when you originally signed the document, and why you didn’t actively insist on a discussion. With the help of your lawyer, that was your job to make sure that happened. You had the choice to call off the wedding and/or sit down and read every page. I’m not saying this to be provocative, but to remind you that taking responsibility for this sequence of events is more constructive than taking umbrage at your husband.

But let’s be very clear: Three days notice of a prenuptial agreement before your wedding without any willingness to compromise on the details or discuss them is sorely lacking in consideration, and is a chaotic and unsettling start to a marriage. I understand why it left you reeling, and why you felt both confused and angry. Prenups are enforceable in Pennsylvania, which is a marital property state, meaning that — in the absence of a prenup — assets are distributed in a fair and equitable manner. Inheritance is not considered marital property, so you should have no worries on that front.

Your prenuptial agreement should reflect that you both maintain your separate finances/assets in the event you divorce. In other words, what’s his is his and what’s yours is yours. He can’t have it both ways. According to Rowe Law Offices in Pennsylvania, “Historically, courts sometimes set aside premarital agreements when they were unreasonable; left one spouse destitute; were made without full disclosure of a spouse’s property and debt; were signed under duress or without mental capacity; were the product of fraud or misrepresentation; and so on.”

Should you amend the prenup? You can certainly create an amendment, as long as both of you are in agreement, or sign a new postnuptial contract that supersedes the original contract. But that is a question only you can answer based on what the prenup actually says, and whether you lawyer believes it is written in a way that gives you both the same financial independence post-divorce. The whole business seems messy and unpleasant. It was not a good way to embark on a marriage and, as a tangent to your question, it’s not a good way to continue one.

Certainly something needs to change. From the little you have said, it appears to be a marriage that lacks transparency and mutual respect. You need a financial therapist, a mediator or your own counselor to examine the causes and cures of this toxic atmosphere. Starting a business should be a time of optimism and joy, not steeped in an “I’ll show you” entrepreneurial revenge fantasy. Getting married is the biggest financial decision you will make in your life, if only because the toll divorce takes on an individual, and because you may end up taking turns supporting each other.

If this marriage ends, you should both leave with what you brought into it. Given that, the real issue here is not what happens in the event of a divorce, but everything else that comes before it.

The Moneyist:My wife has homeschooled our son and our best friends’ son since September due to COVID-19. Is it too late to bring up money?

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 group where we look for answers to life’s thorniest money issues. Readers write in to me with all sorts of dilemmas. Post your questions, tell me what you want to know more about, or weigh in on the latest Moneyist columns.

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