Bubbles tend to be formed when there is an element of novelty in the world. Innovations create some uncertainty which the human mind is quick to translate into overly optimistic expectations. That novelty can be triggered by technology as well illustrated by the Gartner Hype Cycle (e.g. the 2001 Tech bubble, cryptocurrencies) or by novelty in the financial instruments that support an asset or an asset class (the financial innovation which fueled the 2004-06 housing bubble or the large-scale LBOs in the 80’s). I would add a third bubble risk factor to his list: novelty in monetary policies – and there has been plenty of it since the Great Financial Crisis.
In ‘Higher For Longer’ in July 2016, a visit was paid to the Gordon Growth Model (also known as the Dividend Discount Model) to seek to explain why elevated valuation multiples were supported by financial theory and why the situation may persist in 2017 (as it did). According to this well-known model, the price-earnings ratio is equal to the dividend pay-out ratio divided by the discount rate minus the expected long-term nominal growth rate. All other things being equal, the smaller the difference between the discount rate and the growth expectations, the greater the multiple. Here is an attempt to illustrate the stock market valuation dynamics with a simple table:
The higher valuation multiples enjoyed over the last three years despite lower earnings growth prospects (green vs. red ellipse) are supported by the compression of the difference between the risk-free rate-driven discount rate and the nominal growth expectations (from 300bps to 250bps in this example). That smaller delta may live on as growth, inflation and rates move upwards in tandem in a post-crisis world of lower long term growth expectations, lower inflation (with some mild deflation risk), and lower equilibrium or ‘neutral’ interest rates (as per the yellow ellipse in the matrix).
Should this scenario prevail, monetary policy would normalize whilst the currently elevated multiples would become the new norm in a new world. With the price-earnings multiple at its long-term equilibrium, the US stock market may go up at a speed that is roughly in line with that of earnings growth in 2018 – call it 7-9%.
Needless to say, inflationary pressures may prove stronger than expected next year and in their worst form could lead to an ‘inflation shock’. If faced with an unexpected burst of inflation, the Fed would tighten its rates faster than anticipated which would shake the balanced macro-economic picture portrayed last week. The tighter spread between the cost of capital and growth spurred by novel monetary policies would prove illusory. The consequences would not be pleasant as the price-earnings ratio would mechanically contract to a point that would unlikely be offset by higher growth expectations.
Inflation is arguably the biggest macro-related risk to financial markets. For what it is worth, the Fed stated in the latest FOMC minutes released this week that ‘inflation would reach the Committee's 2% objective in 2019’ and that ‘risks to the projection for inflation […] were seen as balanced’ (Note: ‘inflation’ appeared 113 times, ‘labor’ or ‘(un)employment’ 79 times and ‘GDP’ just 8 times in these FOMC minutes as a sign of the Fed’s focus).
With inflation under control, 2018 should be another constructive year for equities and for IPOs. It should also be conducive to active portfolio management through M&A activity in the Diversified Industrials sector – especially as it is subject to increasing pressure to rejuvenate itself.