Outside the Box: Why high stock prices could be here to stay

Some people say a bull market isn’t over until the last bear has thrown in the towel. Either legendary value investor Jeremy Grantham has just done that, or he’s correct in arguing that something fundamental has changed in the economy and the stock market.

In his most recent shareholder letter, Grantham wondered if corporate profit margins and stock prices have elevated to a new permanent plateau or mean. That’s a radical consideration for an investor who called the technology bubble of 2000 and the housing crisis of 2008 by relying on historical data to define bubbles as two-standard deviation or more events.

In other words, if a normal or long term average valuation for the U.S. stock market is a Shiller PE of 16.5 and the standard deviation of the metric is around 6.5, then a Shiller PE of 30 or twice the standard deviation away from the mean should get us to bubble territory. And that’s where we are now in the stock market. Similarly, if median home price relative to median family income is x and standard deviation is x+/-2, then x+4 defines a bubble in home prices.

But Grantham is saying the historical data isn’t so relevant now. He and his Boston-based firm Grantham, Mayo, van Oterloo (GMO) use the Shiller PE among other tools to appraise stock markets’ relative attractiveness. They are also sensitive to profit margins, which, historically, have had a pronounced cycle of expansion and contraction. Grantham has said repeatedly that profit margins are the most mean-reverting data set in finance — and they should be, if the theory of capitalism holds. That’s because competition should eventually suppress excess profits wherever they may temporarily appear.

But, lately, profits have been stubbornly high — as have stock valuations, especially in the U.S.



 



While the Shiller PE averaged around 15 from 1880 through 1996, it has averaged about 27 since 1997. Moreover, according to numbers I found on the St. Louis Federal Reserve website, corporate profits averaged around 6% of GDP from 1960 through 1996, but since 1997 have averaged close to 8% of GDP. (GMO presents data from 1970 instead of 1960, and the firm’s numbers are nearer to 5% and 7% for those same two time periods, respectively. But they tell the same story.)

Why margins are fat

Historically low interest rates and higher leverage may be an explanation for higher margins, but Grantham doesn’t seem convinced. Competition should still compress profits, after all. However, globalization, aging populations, below-trend growth in both population and productivity, and greater inequality are also significant differences between the current economy and the past.

Ultimately we live in a time when companies wield more monopolistic, political and brand power, according to Grantham. There are fewer larger corporations that enjoy more clout because there are fewer new entrants than before. Globalization has also increased the presence of American brands around the world. Even mediocre American companies have enjoyed elevated profits from moving work overseas. Finally, increased regulation hasn’t crimped profits so much as it has helped entrench incumbents and increase their profits. “The corporate establishment’s enthusiasm for less regulation is misguided,” Grantham says.

Overall, higher margins support higher stock prices, and lower interest rates (and greater leverage) support higher margins. And, finally, monopoly power prevents competition from eroding profits, which otherwise should happen in a time of lower rates and greater leverage.

Grantham thinks higher interest rates could foster more profit-eroding competition. The problem is that he doesn’t see rates going up enough to do that anytime soon. He ends his letter saying that high stock prices, and the elevated profit margins which support them, may persist for an uncomfortably long time.

 

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