By Ivan Petrella, Davide Delle Monache and Fabrizio Venditti 

The fast rebound of US stock prices following the COVID-19 shock has reignited discussions over frothiness in stockmarkets.

Despite a global lockdown, according to The Economist, between the start of April and the end of August, with central banks pinning bond yields down, global stockmarkets rose by 37 per cent.

When compared to expected earnings, stock prices appeared simply very high, painting a picture of overly optimistic investors. The risk is that high valuations might be baking a future stockmarket crash.

High valuations, however, are not the outcome of exuberant stock investors pricing a fast recovery from the great lockdown. From a longer-term perspective, they appear to be the end-point of a more persistent trend.

Annual data since 1880 suggests that the Price-Dividend (PD) ratio - a measure of the return an investor makes for every dollar invested in the company - has been trending upwards since the 1950s, with two sharp accelerations, one in the 1960s and one in the 1990s. Deciphering the underlying causes of this trend could shed some light on current stockmarket behaviour.

Financial economics offers a simple framework to think about stock valuations. John Campbell and Robert Shiller revealed in 1988 that movements in the PD ratio fully reflect expected cash flows (ie dividend growth) or the expected return on stocks. Thus, the higher expected cash flows then the higher stock prices compared to current dividends.

Expected return on stocks, the discount rate used by investors when discounting future cash flows, is instead inversely related to the PD ratio. Attractive valuations are incompatible with low expected returns and (vice-versa) high valuations suggest that prices do not have much room left for growing further, so that expected returns must be low.

The Campbell and Shiller decomposition could shed some light on the factors that have pushed stock valuations in the past 70 years, whether high expected dividend growth or low expected returns. 

This exercise, however, is less trivial than it might seem. It needs, in fact, an econometric model that does two things at the same time: first, separating a trend component from transitory fluctuations, so as to filter out the expected components of dividend growth and stock returns from temporary shocks; second, imposing the exact decomposition of the PD ratio proposed by Campbell and Shiller on these two trends. 

In a recent paper, we develop a new econometric methodology that is fit for this purpose, and use it to analyse the time varying relationship between stock valuations, expected dividend growth and expected returns in a long-run perspective.

We document that the secular rise in valuations is mainly due to lower expected stock returns, which have fallen, over the last 150 years, from roughly eight per cent to four per cent. The long run growth of dividends has also fallen but only mildly, from two per cent to 1.5 per cent and cannot account, quantitatively, for the rise in valuations. 

This result is fairly intuitive. In a world of secular stagnation, ie low growth and low interest rates, one would not expect dividend growth but rather low discount rates to raise stock prices. Our work provides an exact decomposition of the contribution of these two factors.

But why have discount rates fallen so much? Stocks are valued like ‘bonds plus risk’. Hence, either the long-run expected return on bonds (a measure of r-star - the natural interest rate when there is full employment and inflation is constant and so saving and investment is balanced without causing unsustainable recessions or booms) has fallen, or risk appetite has increased. 

In our paper, we further delve into this question and use our methodology to decompose expected stock returns into a safe component and a long-run equity premium. We find that the former is mostly responsible for the rise in stock valuations. 

According to our analysis, r-star has fallen from around three per cent in the 1950s to a current value of about 0.5 per cent. The long-run equity premium, on the other hand, has remained roughly stable. If anything, it has slightly risen after 2000.

Our findings have important implications for interpreting current market conditions. First, our work confirms that discount rates, rather than dividend growth, need to take centre stage in the debate over stock prices, just as John Cochrane's research revealed in 2011. 

Further, the behaviour of stock prices throughout the COVID-19 crisis is, in this respect, no exception. The pandemic recession has dealt yet another blow to the equilibrium interest rate, and global monetary policy accommodation has further reduced the yield on short and long-term dated Government bonds. As the bond yield squeeze is set to persist for a long time, investors will keep reaching for yield, and valuations will remain above their long-term average.

Second, the low level of interest rates at which markets entered the current crisis could have further exacerbated this reach for yield. In a recent paper, Campbell and Robert Sigalov show that investors reach for yield as risk-free rates fall and the equity premium remains constant (exactly what has happened in the past 150 years according to our analysis).

They also show that the lower the initial level of interest rates, the more investors reach for yield as rates fall further. Thirdly, our analysis sheds some light on the role that monetary policy (relative to other secular factors) has played in boosting stock prices. 

According to our results, the fall in the safe real rate of interest pre-dates the wave of liquidity injected by central banks into financial markets since the global crisis. This suggests that, as Richard Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas have argued, it is secular factors like an ageing population, rising scarcity of safe assets and the fall in the equilibrium rate of economic growth that are mostly responsible for persistently high stock valuations, rather than monetary policy itself.

Read the original article at Voxeu.

Further reading:

Delle Monache, D, I Petrella and F Venditti (2020), “Price dividend ratio and long-run stock returns: a score driven state space model”, European Central Bank Working Paper Series.

Ivan Petrella is Associate Professor of Finance and a Research Affiliate at the Centre for Economic Policy Research. He teaches Advanced Monetary Policy on the MSc Global Central Banking & Financial Regulation.

Davide Delle Monache is an Economist at the Bank of Italy.

Fabrizio Venditti is Principal Economist in the Directorate General International at the European Central Bank.

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