Investing

Valuation is Not a Catalyst

I’m not a Fed Model disciple but I feel it is among the best explanations, if there are any, for market valuations this cycle. As I’ve mentioned in the past, the model has several shortcomings but provides fairly insightful relative context between the last three business cycles.

The cycle leading up to the dot com bubble could be characterized as a growth driven market as expectations for technology’s contribution to growth increased exponentially.

The cycle last decade leading up to the financial crisis could be characterized as a credit/financial engineering driven market as credit related investment products synthetically increased the credit supply available to everyone.

I like to characterize the current cycle as an opportunity cost driven market. A low yield environment has been created by central banks pushing capital out of traditionally safer assets into riskier assets to obtain desired yields. Naturally, asset prices have been driven up creating much consternation in the financial press and blogosphere. I’m not arguing that absolute valuation levels are not high. However, in the absence of a better alternative capital is going to flow into higher yielding assets at this point, all else equal.

As I mentioned here, the current spread between earnings yields and nominal and real interest rates continues to be above levels on the eves of the last three U.S. recessions. I’m neither making a call nor suggesting a bear market isn’t imminent. However, I don’t believe valuation levels in and of themselves tell us anything about the market’s next inflection point. The Fed or a fundamental or exogenous shock will likely be necessary to start the next correction and/or bear market, not absolute valuation levels.