Why are stock markets so high?

Economies are yet to recover from Covid-19, and yet despite the economic chill, the bull is still charging, with stock markets at all-time highs.

Paul Brownsey Paul Brownsey 3 minute read

The stock market sell-off caused by Covid-19 last March really is a distant memory now.

Stock markets around the world have recovered mightily with US equity markets hitting all time highs.

Yet economies are still struggling, and economic activity is generally lower than early last year. 

So, what’s going on?

Take Microsoft, a great company found on almost every fund managers’ buy list.

Early last year, it was trading at US$170 (NZ$244) per share.

Today, it’s around US$255 per share.

A first check on the value of a company is to look at the price to earnings ratio (PE).

This takes the share price of a company and divides it by the company earnings (profits) per share.

A low PE implies cheapness, a high PE expensive-ness.

An intuitive way to think of PE is that the ratio tells you how much money you are investing now in a company for each dollar of its earnings.

So pre-Covid-19, when you bought Microsoft, you would have been buying its earnings stream for $26.

Today you are paying $32, a premium of nearly 40 per cent.

Is that rational?

The answer is, “maybe”.

Currently, interest rates around the world are very low.

All else being equal, lower interest rates mean investors are typically more willing to pay higher valuations.

With rates being low, investors also move towards shares as an investment with money being “cheap”, particularly those shares which pay an attractive dividend as some investors search for income.

What could go wrong with that?

Potentially quite a lot.

By historical standards, lofty valuations of companies is dependent on interest rates remaining low.

But what happens if interest rates rise to 2 per cent, or 3 per cent, or higher?

And all of a sudden, the relative attractiveness of shares as an investment decreases.

It is no surprise then, that the major question on investors’ minds is when will rates rise?

Listening to Central Banks, including the Reserve Bank of New Zealand, the answer is no time soon.

Central Banks have the power to force interest rates low and keep them low. It is a brave investor that bets against Central Banks in this environment.

The Reserve Bank is not tipped to lift interest rates by Westpac economists until 2025. 

The most dangerous words to hear in investing are: “It’s different this time”.

That phrase is usually uttered just before markets doing something which shows that it’s not actually different this time. 

In the week ahead, we will receive news which could have a significant effect on interest rates.

Inflation numbers set to be released in the US this week are likely to show that inflation has surged above 2.5 per cent. Higher inflation implies higher interest rates.

The rational response would be for interest rates to rise above the inflation rate so that the purchasing power of a dollar is not eroded by inflation.

This would likely cause stocks like Microsoft to cheapen.

It is difficult to accurately predict what may happen to markets if inflation rises as much as expected next week.

But one thing investors should not do is actively bet against Central Banks and their power to keep rates low.

As well, we are moving into US corporate earnings season.

US listed companies will start to report their quarterly profits.

While expectations are good, there is always the possibility of negative surprises.

Many commentators are calling the current mix of high company valuations against a backdrop of low interest rates and rising inflation irrational.

But as John Maynard Keynes famously said, ”Markets can remain irrational longer than you can remain solvent”.

Paul Brownsey is Chief Investment Officer at Pathfinder Asset Management, and KiwiSaver provider Pathfinder. His views in this article are general only and are not recommendations for any particular person in relation to any share or financial product. The original version of this article was published in Stuff, on April 12, 2021.

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