Is the market a bubble ready to burst? In recent threads, I examined that question from a variety of angles, using a discounted cash flow (DCF) model, which helps us quantify the effects of today’s ultra-low interest rates and abundant financial engineering. A summary: (THREAD)
Without even getting into the equity risk premium and payout ratio, it's fair to say that today’s low rates have added 5 P/E points to the market’s valuation, and the many trillions in buybacks since 2004 has added another 5 points. /2
That’s 10 P/E points of additional valuation. Absent these factors, the S&P 500 would trade at a 15x trailing P/E instead of 25x. Coincidently, 15x was the average P/E ratio for the market’s entire history prior to the current era. /3
In a hypothetical, worst-case scenario in which rates revert to where they should be based on inflation, the ERP goes back to average, and the buyback era ends, the market’s current 25x P/E could be cut in half. /4
A 50% haircut, not from an earnings decline but simply a return to past conditions—this is NOT a prediction!--- might indeed leave many investors thinking it was all a big bubble. /5
I’m not convinced that we can lay all the current market attributes at the feet of the Fed, but clearly, the combination of share buybacks and low interest rates have had a big impact on the stock market. /6
In my view, interest rates are repressed by the Fed, and this could well continue for some time. That means that the stock market is 25% higher than it would otherwise be, but this can remain the case for a long time. /7
Having said that, at 1.3% the 10-year yield probably has more upside than downside, and all else being equal, that should be a drag on valuation. /8
In my view, only an earnings decline or regulatory action will slow the buyback train. So long as rates are low and companies produce more cash flow than they can put to use, they will buy back shares, inflating EPS and raising the payout. /9
A bubble? No, not in the classic sense. Distortions through policy and financial engineering? You bet. Can it last? You bet. /END

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More from @TimmerFidelity

15 Jul
Is the market a bubble ready to burst? In this thread, we'll consider what share buybacks have to say about it: (THREAD)
With dividends being relatively stable and the DCF placing a lot of weight on the terminal value (long-term growth after 5 years), the main variable to consider is the pace of share buybacks, which affect the payout ratio. /2
Historically, earnings growth has been 6% in the US, and in recent years the payout ratio has been around 90%. Currently (a/o Q1) it’s 71%, with dividends comprising 35% and buybacks 36%. /3
Read 21 tweets
14 Jul
Is the market a bubble ready to burst? An important factor to consider is the risk-free rate (RFR), aka the 10-year Treasury yield. So let's dive in: (THREAD)
It doesn't take a leap of faith to see that monetary policy is suppressing interest rates. This chart shows it. Nominal yields on the vertical axis and TIPS break-evens on the horizontal. The size of the bubbles (no pun intended) shows the size of the Fed’s balance sheet. /2
Based on the regression between these two variables, the current level of the 10-year is about 100 bps lower than it “should” be. This chart shows the 10-year vs the above TIPS model. Are today’s subdued yields the result of policy? It seems that way to me. /3
Read 10 tweets
13 Jul
Following up on the previous thread, as we seek to answer the question: “Is the market a bubble that is ready to burst?” The next factor to look at is the equity risk premium. (THREAD)
The discount rate (or cost of capital) consists of the risk-free rate (10 year Treasury yield) plus the equity risk premium. The ERP is like a credit spread, reflecting the additional return investors demand as compensation for additional volatility vs. the risk-free asset. /2
The surge in “excess money” (money supply growth less GDP growth) resulting from the fiscal/monetary response to the pandemic has clearly elevated the market’s valuation, as the chart below shows. /3
Read 13 tweets
13 Jul
With stocks trading at near-record valuations and the Fed hoping to retreat from the zero lower bound (ZLB) and its $120 billion in monthly asset purchases, everyone wants to know: Is this market a bubble that is about to burst? Let's take a hard look. (THREAD)
I’m going to try the process of looking at all the market’s moving parts through the lens of the discounted cash flow model (DCF). It’s a good exercise in discipline in that it forces me to actually quantify the puzzle pieces.
For the DCF there are four important variables that we need to consider: earnings growth, the payout ratio (dividends + buybacks as a percent of earnings), interest rates, and the equity risk premium. /2
Read 9 tweets
12 Jul
Sentiment. It finds its way into a lower ERP, as it did at the secular peak in 2000, but we can also measure it through investor behavior. (THREAD)
We know about speculation in meme stocks & non-profitable tech this cycle. Margin debt has growth dramatically on a year-over-year basis, although as a percentage of market cap, margin debt remains well below the peak in the 2000s. /2
With retail speculation presumably limited to a relatively small subset of the market, looking at long-term flows--that is, regular investors saving for retirement--we see very little evidence of exuberance. /3
Read 5 tweets
23 Jun
With all the speculation about the Fed raising interest rates sooner than later, let's take a look at how past "liftoff" attempts by the Fed affected the markets, and how the Fed then responded. (THREAD)
There have been four major liftoff attempts since the Global Financial Crisis. The first was in April 2010, after an 80% run in the S&P 500. The Fed ended QE1, producing a three month, 16% drawdown for stocks, which forced the Fed to start QE2 a few months later. /2
The second attempted liftoff gave us the infamous taper tantrum in May 2013 (8% drawdown). The third was the actual liftoff in 2018, which ultimately produced a brief but scary 20% decline for stocks. And now we are in the early stages of the fourth liftoff attempt. /3
Read 12 tweets

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