Will the equities keep going up despite valuation?

Equities have been on an upward swing, and Davey day trader says that stocks only go up. Clearly that is not true over periods of 1,2,5 years or even some decades. We will focus on what is driving the US equities up, and what is the medium to long term outlook.

A lot of people have talked about the high valuation, weakness of the economy, high unemployment and other factors. However, there are a number of factors why the stocks have positive drivers in the medium to long term:

1. Upward momentum due to passive investing
2. Low interest rates
3. Expectations of better returns than most other asset classes
4. Build-up of savings on the sidelines
5. Fed provided liquidity and re-investment of benefit checks
6. US viewed as a safe haven vs. rest of the world
7. Innovation and productivity growth

We will discuss each of the factors now.

1. Upward momentum due to passive investing: This argument has been primarily forwarded by Mike Green of Logica. The underlying argument here is that younger generations are investing in passive funds either through 401K or even through retail brokerage accounts. This kind of investment through the passive funds does not rely on valuation, and essentially just buys as money flows in. This type of driver may then help large cap funds a bit more as a lot of the passive investing goes into S&P 500 funds.

2. Low interest rates: In simple terms, low interest rates increase the present value of cash flows making the value of a company higher. This driver will also disproportionately impact the long duration cash flow companies (such as growing tech and bio-tech companies).

3. Expectations of better returns than most other asset classes: Shiller PE ratio (CAPE) is currently at 30.5 as of 09/19/2020. This implies a longer term return of about 5% (which includes a dividend yield of about 1.7%). A 5% return seems astronomical when compared to the treasury returns, further justifying the inflows into equities.

4. Build-up of savings on the sidelines: Savings have increased to record levels post-Covid. Given the historical tendencies of US population, one will expect to find this money back into the market and the economy at some point driving returns and recovery.

5. Fed provided liquidity and re-investment of benefit checks: Stimulus check provided by the government and the unemployment benefits have led to rise in “investing” through traditional and “fractional share” platforms driving activity in the market by the small retail investors. This has also spurred the call buying in tech stock (such as Tesla) by these investors. Longer term additional fiscal actions by the government or institution of Universal Basic Income (UBI) might potentially drive stocks higher, along with inflation.

6. US viewed as a safe haven vs. rest of the world: US equities are one of the best performing markets post-covid. European equities have struggled. If you are in one of the countries in LatAm or other places which lack the ability to generate resources to fight pandemic effect, US appears to be a great place to put in your investments.

7. Innovation and productivity growth: Overall, US remains the leader in terms of entrepreneurship and innovation. The recent push in bio-tech driven by pandemic response which combine artificial intelligence, genome sequencing and testing have accelerated vaccine development to a speed that was unfathomable even a few years back. US continues to lead in term of Electric Vehicles / Autonomous Vehicles technology. While China is ahead in 5G and artificial intelligence, US is very close. Overall, longer term productivity growth will drive the longer term economic improvement and support the markets.

I am not discounting the drivers of volatility in equity prices. This includes potential for societal unrest that we are seeing in the various cities in US, short term uncertainty around presidential elections, trade wars, and potential geo-political wars, decline in USD hegemonic position, potentially “chaotic” behaviors of the market with increase in passive funds.

Given the positive drivers I believe that Equity should occupy a sizable position in your well diversified portfolio (~30-40%). There also needs to be defensive assets in place that will maintain your purchasing power in case of major equity draw-downs.

In closing, as Ray Dalio mentions, post Covid-19 the paradigm for investing has changed. We are going to go through a few transition years where keeping abreast of changes will be particularly important. These blogs help me articulate my points of view and make me critically examine and refresh my beliefs. I will continue writing about other asset classes and their role in your portfolio.