Today’s Low Interest Rates Should Make Us Even More Concerned Over Today’s High Stock Prices

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Today’s Low Interest Rates Should Make Us Even More Concerned Over Today’s High Stock Prices
<a href="https://pixabay.com/users/StartupStockPhotos/">StartupStockPhotos</a> / Pixabay

Robert Shiller recently published an article observing that: “In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases and the price of the equity asset should appreciate, assuming all other model inputs stay constant. So, interest-rate cuts by central banks may be used to justify higher equity prices and CAPE ratios.”

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Equities Will Continue To Look Attractive As Long As Interest Rates Are Low

Thus, Shiller argues that: “despite the risks and the high CAPE ratios, stock-market valuations may not be as absurd as some people think... With interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.”

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I don’t feel comfortable with this line of thinking. It certainly makes sense that low interest rates make stocks look more appealing in relative terms. But I am disinclined to look for rational justifications for high stock prices. Shiller reveals a compelling cause for high stock prices in the title of his book -- irrational exuberance. Investors are not thinking clearly when they permit the CAPE value to rise to where it rests today (today’s CAPE is in the same general neighborhood as the CAPE value that brought on the Great Depression).

The tricky thing, of course, is that investors do not ever acknowledge the irrationality of their exuberance at the time that it is evidencing itself. If they did, they would feel a need to do something about it. There’s only one sensible thing that they could do -- lower their stock allocation to bring their risk profile back to a reasonable level. If they did that, the stock sales would pull prices down and the irrational exuberance would disappear.

There can never be a rational explanation for irrational exuberance. But investors do possess a desire to justify their behavior. And, the more irrational the behavior is, the more a seemingly rational explanation is required to make scary, prudent thoughts go away. Shiller is playing a dangerous game in telling investors that things may not be as bad as the CAPE level indicates. If they truly are behaving irrationality, as the CAPE level strongly suggests, they are going to find unjustified comfort in his words.

Of course, his words need to be heard if it really is the case that today’s CAPE level is sending a false signal of exaggerated alarm. I question whether that is the case.

Drop In Stock Prices

Say that today’s interest rates were high rather than low. In that event, a drop in stock prices that threatened to turn into a collapse could be addressed with a lowering of interest rates. With interest rates already at rock-bottom low levels, that option is not available to us. It seems to me that having both high stock prices and low interest rates at the same time is the worst of all possible worlds. There’s pressure on stock prices to fall and there’s pressure on interest rates to rise and either outcome could potentially bring on a wipeout of trillions of dollars of investor wealth.

Shiller says that the low interest rates are “likely to stay there.” He doesn’t say why he believes that. Economic conditions do not remain the same indefinitely. Every crash that we have seen was unexpected. If it had been expected, that expectation would have brought stock prices down and diminished the size of the crash. It is when investors stop worrying about a crash that the danger of a crash is the greatest. I see this as an article that will cause many investors not to worry so much about a crash. It is my view that people should be very worried.

Please remember that interest rates are “priced in” to the market price for stocks. But irrational exuberance is never priced in. It is the one factor that by definition cannot be priced in because the process by which factors are priced in is a rational process and irrational exuberance takes place outside of rationality (the rational thing would be for investors to price stocks properly).

I believe that Shiller has advanced the ball with this article. It gives everyone in the field something to think about. I look forward to seeing what lots of smart people have to say about it.

Rob’s bio is here.

Previous article Overstretch: The Long Shadow of Soaring US Debt 
Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”

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