Let’s suppose that you have money on deposit in a bank, in some kind of checking or savings account. It’s paying you 2.5% per year, which isn’t something you can easily get in 2017, but something that would have been possible several years ago. As a friend with lots of advice to give, I come up to you and strike up the following conversation:
Me: “Why are you tying up your money in a bank for such a low return?”
You: “But I’m not tying it up. I can still use it if I need to. I may have to pay a penalty, but it’s still there for me to access.”
Me: “Oh no, it’s not there.”
You: “How is it not there?”
Me: “The bank loans it out to people. So it’s not there for you to access. They keep a small portion on reserve that they can give out in case people want to withdraw money, but if there’s ever a situation where a sufficient number of people lose confidence in the bank and try to get their money out at the same time, the money’s not going to be there. You’re going to be screwed.”
You: “Well, what should I do instead?”
Me: “You should keep the money in a safe. When you keep it in a bank, you’re taking on risk for a paltry potential return. That’s stupid.”
Let’s neglect for a moment any potential banking system misconceptions revealed in this conversation. The question I want to ask is: does it make sense, for reasons of convenience and for the potential to earn a few hundred additional basis points of interest, to keep money in a bank rather than in a personal safe? Assuming the bank is soundly managed and has a fundamentally solvent balance sheet, the only risk to your money is the possibility that everyone might rush to take money out of it at the same time. There’s a network of confidence that buffers against that possibility. Nobody expects people to panic and try to take money out, therefore a people don’t panic and try to take money out, and the system holds up. Assuming there’s strength and stability in the network of confidence, it can make perfect sense to opt for the added convenience and the extra 2.5% over cash.
In our modernized banking system, this point goes even farther. The network of confidence is dramatically strengthened by the fact that there’s government insurance on deposits, and also by the fact that there’s a central bank with a charter to provide liquidity to solvent institutions that need it. There’s essentially no possibility that a financially sound bank could ever be destroyed by a bank run. And so if your choice is to keep money in a safe or earn 2.5% at such a bank, you should always choose the bank option.
There are valuable parallels here to asset markets, particularly in environments like the current one where short-term rates are expected to remain very low over the long-term. I’m going to explain those parallels in a bit, but before I do that let me first clarify some concepts that I’m going to make reference: financial asset and intrinsic value.
A financial asset is an entity that pays out a stream of cash flows to the owner over time. The intrinsic value of a financial asset is the maximum price that an investor would be willing to pay to own the stream if she enjoyed no liquidity in owning it–that is, if she were required to hold it for the entirety of its life, and couldn’t ever take her money out of it by selling it to someone else. To illustrate the concept, consider a share of the S&P 500. In essence, each share is a claim on a dividend stream backed by the earnings of 500 elite U.S. companies. The stream grows in real terms over time because some of the earnings are retained to fund acquisitions and business expansions, which increase the cash flows and dividends that can be paid out in future periods. Last year, each share of the S&P 500 paid out around $45 in dividends. Next year, the number might be $46, the year after that, maybe $47, and so on. There will be sudden drops now and then, but the general trend is upward.
Obviously, estimates of the intrinsic value of a given security will be different for different investors. A useful way to estimate that value for a security you own is to ask yourself the question: what is the most you would be willing to pay for the security if you couldn’t ever sell it? Take the S&P 500 with its $45 dividend that grows at some pace over the long-term–say, 2% real, plus or minus profit-related uncertainty. What is the most that you would be willing to pay to own a share of the S&P 500, assuming you would be stuck owning it forever? Put differently, at what ratio would you be willing to permanently convert your present money, which you can use right now to purchase anything you want, including other assets, into a slowly accumulating dividend stream that you cannot use to make purchases, at least not until the individual dividends are received?
When I poll people on that question, I get very bearish answers. By and large, I find that people would be unwilling to own the current S&P 500 for any yield below 5%, which corresponds to a S&P 500 price of at most 1000. The actual S&P trades at roughly 2365, which should tell you how much liquidity–i.e., the ability to take out the money that you put into an investment–matters to investors. In the case of the S&P 500, it represents more than half of the asset’s realized market value.
Now, here’s where the parallel to banking comes into play. As with a bank, a market’s liquidity is backed by a network of confidence among its participants. Participants trust that there will be other participants willing to buy at prices near or above the current price, and therefore they themselves are willing to buy, confident that they will not lose access to their money for any sustained period of time. Their buying, in turn, supports the market’s pricing and creates an observable outcome–price stability–that reinforces trust in it. Because the investors don’t all rush for the exits at the same time, they don’t have a need to rush for the exits. They can rationally collect the excess returns that the market is offering, even though those returns would be insufficient to cover the cost of lost liquidity.
When the network of confidence breaks down, you end up with a situation where people are holding securities, nervous about a possible loss of access to their money, while prevailing prices are still way above intrinsic value, i.e., way above the prices that they would demand in order to compensate for a loss of liquidity. So they sell whatever they can, driving prices lower and lower, until confidence in a new price level re-emerges. Prices rarely go all the way down to intrinsic value, but when they do, investors end up with generational buying opportunities.
Recall that in our earlier example, you have two options. You can hold your money in a safe, or you can hold it in a bank. The safe gives you absolute security–no possibility of ever losing access to the money. The bank gives you a 2.5% extra return, plus convenience, all in exchange for risk to your access. Granted, you can get your money out of the bank whenever you want–but only if the network of confidence that backs its liquidity remains intact. Because you believe that the network of confidence will remain intact, you choose the convenience and the added return. Our modernized banking system simplifies the choice dramatically by externally bolstering the network through the use of mutual insurance and the designation of a lender of last resort. And so there’s not even a question as to whether you should take the convenience and additional 2.5% return that the bank is offering. You should take any extra return at all, all the way down to zero, because there’s essentially no risk that the network that backs your access to the money will ever break down.
Investors face a similar choice. They can hold their money in cash, and earn a low return–in the current case, 0%–or they can purchase an asset. The cash gives them absolute, unrestricted access to their money at all times, whereas the asset gives them imperfect access, access that’s contingent, at least in part, on the sustained preferences and expectations of other investors. In compensation for that risk, they get an extra return, often a large extra return.
The question comes up: in a low rate world, with assets at historically high valuations, offering historically low returns, what should investors do? Should they opt to own assets, or should they hold cash? The point I want to make in all of this is that to answer the question, we need to gauge the likely strength and sustainability of the market’s network of confidence amid those stipulated conditions. We need to ask ourselves whether investors are likely to remain willing to buy at the high valuations and low implied returns that they’ve been buying at. If the conclusion is that they will remain willing, then it makes all the sense in the world to buy assets and continue to own them. And if the conclusion is that they won’t remain willing, that something will change, then it makes all the sense in the world to choose hold cash instead.
If we’re living in a low-rate world, and our only option other than holding cash is to buy the S&P at 30 times earnings, or a 30 year treasury at 2%, or whatever other shitty deal is on offer, and you ask me what we should do, I can only answer the question by asking whether there will continue to be a ready supply of buyers at those valuations into the future. And the point is, regardless of what “historical averages” have to say about the matter, there may continue to be! As always, path is crucial. If valuations have arrived at their current levels through short-term excitement and mania, then we should be more suspicious of their forward-looking sustainability. The network of confidence sustaining those valuations is likely to be fickle and to eventually break down. But if prices have gradually moved to where they are over a long period of time, in response to legitimate secular market forces and conditions, if participants have had sufficient time to grow accustomed to them, to psychologically anchor to them, such that they see them as normal and appropriate, then the basis for questioning their sustainability isn’t going to be as strong.
It’s important to remember that as long as cash is yielding zero or something very low, there’s no arbitrage to force asset prices lower, no dynamic to force them to conform to some historically observed level or average. They can go as high as they want to, and stay as high as they want to, provided investors are able to develop and retain the confidence to buy at those levels. Note that the same point doesn’t hold as readily in the other direction, when considering how low prices can go. That’s because financial assets have intrinsic value. Below that value, they’re worth owning purely for their cash flow streams, regardless of the prices at which they can be sold. The market can take those prices all the way to down to zero, they’ll still be worth owning as incoming cash flow streams.
People won’t like to hear this, but in the same way that policymakers have introduced structures and practices into the banking system designed to bolster the networks of confidence that sustain banking liquidity, policymakers are capable of introducing structures and practices into financial markets that bolster the networks of confidence that sustain market liquidity. For example, in order to prevent sharp drops that would otherwise be economically harmful, policymakers can use public money to buy equities themselves, providing a direct backstop. Or if that’s not an option legally, they can talk up financial markets, accompanying the talk with whatever policy tools market participants find compelling. If it’s the case, as some argue, that policymaker approaches around the world are evolving in that direction, then that provides yet another basis for valuations to get pushed higher, just as it provided a basis in our earlier example for a depositor to keep money in a bank despite being paid a paltry rate.
It’s often said that bank solvency is an unhelpful concept, given that a bank’s ability to survive is often determined more by its liquidity condition than by anything happening on its balance sheet. Every bank can survive a solvency crisis if given enough liquidity, and every bank can be put into a solvency crisis if starved of enough liquidity. Some would argue, for example, that Lehman failed not because it was truly insolvent, if that even means anything, but because the Fed, right or wrong, refused to lend to it when no one else would. It couldn’t survive the crunch it faced, so it folded. In hindsight, we conclude that it was insolvent. But was it? It’s something of a stretch, but we can find an analogy here to stock market valuation. Every stock market, in hindsight, is seen as having been “expensive” or in a “bubble” when the network of confidence that holds it together breaks down, i.e., when people panic and sell out of it, driving it sharply lower. And every stock market, in hindsight, is seen as “fairly valued” when it suffers no panic and slowly appreciates as it’s supposed to do.
With respect to equity markets in particular, I’ll end with this. If we want to get in front of things that are going to break a market’s network of confidence and undermine people’s beliefs that they’ll be able to sell near or above where they’ve been buying, we shouldn’t be focusing on valuation. We should be focusing instead on factors and forces that actually do cause panics, that actually do break the networks of confidence that hold markets together. We should be focusing on conditions and developments in the real economy, in the corporate sector, in the banking system, in the credit markets, and so on, looking for imbalances and vulnerabilities that, when they unwind and unravel, will sour the moods of investors, bring their fears and anxieties to the surface, and cause them to question the sustainability of prevailing prices, regardless of the valuations at which the process happens to begin.