Jim Grant questions the levels of levity in the stock market in his recent issue of Grant’s Interest Rate Observer.

Formula for stock price valuation off

Citing financial basics, Jim Grant writes: “Repeat after us, Chartered Financial Analysts: The price of a common stock is the present value of the sum of its future cash flows discounted by an appropriate rate of interest (the risk-free rate pus some premium),” Grant notes, citing statistics that only 14.8 percent of time the 10-year Treasury yield has been below 3%.

James Grant Jim Grant
Jim Grant

“Life would be simpler if humans responded to the dividend discount model as obediently as bricks do to the law of gravity.”

“If the discount rate is depressed, the present value of a projected stream of corporate cash flow is reciprocally inflated,” he noted, then humorously commented on the current market levity, saying “Life would be simpler if humans responded to the dividend discount model as obediently as bricks do to the law of gravity.  But, of course, nothing about the interaction of people in markets is cut and dried.”

Noting the competitive nature of free markets, Jim Grant ranted on.  “Most profitable business niches last only as long as the competition takes to discover them. They vanish when a swarm of imitators attacks the innovator with a better idea, lower prices or both at the same time.  As the economists say, returns are mean reverting,” pointing to a potentially improperly valued stock market.

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Jim Grant: Fed distorting markets

Then Jim Grant turned to a favorite topic, the US Federal Reserve:  “We are adamant that the Fed has distorted asset values that we stop short of calling the S&P 500 an air castle.  Federal Reserve policy has made Wall Street a kind of hall of mirrors,” he writes.  “How much higher the market is today than it would otherwise be, we don’t claim to know.  At current valuations, in the context of prevailing profit margins and bond yields, the broad market is more highly valued than it would appear at a glance.  Even at a glance, it isn’t cheap.”  Then Grants notes the S&P 500 is trading at 17 times earnings, the Russell 2000 (INDEXRUSSELL:RUT) at 20.9 and the iShares NASDAQ Biotechnology Index (ETF) (NASDAQ:IBB) at a stratospheric 628.5.

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“We’ve never seen the likes of the past five years”

Markets are distorted, yet, as New York Fed president William Dudley said in a recent Wall Street Journal interview, the market hasn’t collapsed yet, so is there a problem? “What we think we know is that markets are distorted and are likely to remain so,” Jim Grant writes.  “We may observe that, with respect to monetary policy, we have never seen the likes of the past five year.  We do not now contend that the stock market is off its rocker, only that it seems to hold more risk than reward.”

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