Why markets are hitting record highs

Near-zero policy interest rates still fueling stock gains

Since the remarkable equity market reversal in developed countries in late March, many clients have asked whether markets have become irrational. Given the extreme uncertainty surrounding COVID-19, record unemployment, and eye-watering declines in second-quarter GDP, how can the markets have flirted with all-time highs?

Possible answers range from “there’s no alternative” to young investors’ driving the market through new digital investor platforms. Our Investment Strategy Group, however, thinks that the answer is fundamental. And we don’t believe that U.S. equity markets are acting irrationally.

Mathematics and value judgments

At their core, financial markets reflect assessments of the value of assets today based on investors’ expectations for the cash those assets will generate. This concept of net present value is more concretely applied to fixed income, where the known values for yields and coupon payments produce the price. Knowing two of the three values allows investors to determine the third.

The concept applies equally to equity markets. Price plays the same role as in fixed income: Future cash flows equate to the coupon, and the required rate of return equates to yield to maturity. The challenge for equities is the inherent uncertainty around future cash flows – the earnings that companies will reinvest in the business or distribute in dividends.

Much of the assessment of these future cash flows is related to current financial conditions. Because of the market’s forward-looking nature, prices react to changing corporate and economic conditions faster than traditional economic data can.

Three telling events

Though COVID-19 remains a real risk to the global economy, three important things happened in recent months to cause equity markets to reassess return prospects after the fall into bear market territory. Long-term bond yields declined steeply, the Federal Reserve cut its policy rate to zero, and already-low inflation expectations fell even further. These factors caused the required rate of return to plummet. The present value of equities increases as the required rate of return decreases.

Vanguard’s proprietary fair value CAPE (cyclically adjusted price-to-earnings ratio) framework models the relationship among equity valuations, long-term bond yields, and inflation. It shows a fair value range that has moved higher since the first quarter. Interestingly, the S&P 500 CAPE at the end of July falls right in the middle of this range, meaning that valuations as of that date are fair based on interest rates and inflation, which we view as a proxy for the required rate of return.

As for the future...

What does this mean for future equity prices? That depends. A higher fair value range now won’t necessarily remain elevated or continue to increase. Nor does it mean that market prices won’t deviate from fair value temporarily. A normalization in interest rates and inflation expectations would cause fair value to fall (all else being equal), but prices may not immediately follow because of other short-term factors. Over longer periods, though, we’d expect these deviations to revert to fair value as they have over the last 70 years, as shown in the illustration.

Vanguard’s global economics team doesn’t expect monetary policy to normalize anytime soon. On the contrary, we believe the federal funds rate will remain near zero at least through 2021. We also believe that demand-supply imbalances will likely lead to lower (not higher) inflation in developed countries for the foreseeable future, despite unprecedented monetary and fiscal policy. This would suggest that fair value is unlikely to change significantly.

Better-than-expected news about the development of a vaccine or effective therapy could cause equity prices to deviate into overvalued territory. Conversely, if these developments take longer or containment measures prove unsuccessful, prices could move into undervalued territory as market sentiment suffers.

Accurately predicting such surprises and untangling them from market prices is difficult at best. We may not be able to predict the market’s next move with any degree of confidence, but we can say that a reasonable basis exists for its current level.

Kevin DiCiurcio, CFA, is senior investment strategist at The Vanguard Group, Inc. The writer would like to acknowledge the contributions of Kelly Farley and Ian Kresnak, CFA.

Important Notes/Disclosures

© 2020 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Insights“ page of the Vanguard Group, Inc.’s website. Used with permission.

All investing is subject to risk, including the possible loss of the money you invest. Investments in bonds are subject to interest rate, credit, and inflation risk.

The views expressed in this material are based on the author's assessment as of the first publication date April 30, 2020, are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The author may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.

Certain statements in this presentation may be considered "forward-looking information" which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein.

While this information has been compiled from proprietary and non-proprietary sources believed to be reliable, no representation or warranty, express or implied, is made by The Vanguard Group, Inc., its subsidiaries or affiliates, or any other person (collectively, "The Vanguard Group") as to its accuracy, completeness, timeliness or reliability. The Vanguard Group takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this material.

This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and, thus, should not be used as the basis of any specific investment recommendation. Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation.

In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.