Our Insights

About personal finance, investments and markets.
May 9, 2017

All assets are expensive and there is a good reason why

What we are seeing in the investment landscape today is completely unprecedented due to a completely unprecedented retirement/demographic situation. Remember that other time in history when people worked for 20-40 years, then retired for the next 20-40? Yeah…I don’t either. So every time I read an “asset prices will implode” article right next to a “pensions are dramatically underfunded” article I shake my head. Asset prices today are high because people are delaying consumption for future retirement in unprecedented fashion. Make no mistake, equities and real estate are highly valued today. But they are up here on a forced movement out on the risk curve – not crazy speculation.

Stocks are expensive today relative to their historical averages

From 1900-1975, the average cyclically adjusted price-earnings ratio (CAPE) on the S&P 500 was 14.7x. Since 1975, the average CAPE has been 20.1x. Today it is even higher at 29.5x.

Shiller chart2

TINA – There Is No Alternative

Imagine someone in Germany inherited 1 mio Euros. If he/she would have invested that money in 1990 in safe German government bonds with a 10 year maturity he would have generated income of around 90,000 Euros per year. In 2007, that would have dropped to only 40,000 Euros per year. Today with yields as low as 0,4%, the income would have shrunk to a meager 4,000 Euros. Is it a surprise that investors have moved out on the risk curve and bought more equities?

Nice theory – but does it also work in practice?

This is exactly what happened in the real world. Let’s look at Europe’s largest institutional investor, the Norway Pension Fund, which manages approx. €800bn. As you can see on following chart, the equity allocation has gone up from 40% in 1998 to 60% in 2007. At the end of 2016, the central bank of Norway, which manages the fund, has even advocated an increase in the equity allocation to 75%!

Norway equity allocation

Have you heard of supply and demand?

Rising demand for investable assets leads to rising prices. To make matters worse, the supply of retirement-worthy assets has shrunk over the last few years, putting even more upside pressure on valuation. Let me give you two examples:

  • German government bonds: the finance minister wants to reduce the debt levels. This means a lower net issuance of safe government bonds, thus driving up prices (and lowering yields). Bond-buying by the ECB has only exacerbated this trend.
  • US stocks: the number of listed firms on US stock markets has dropped by roughly 50% from 1996 to 2016.

US listed companies

Conclusions

  • The universe of investable assets is shrinking while the need to invest is increasing. This is impacting valuation levels.
  • We are not saying this time is different. We are saying EVERY time is different and markets require context.
  • We are also not claiming higher prices or valuations are here to stay forever. Markets will continue to fluctuate but they may do so around different averages than they once did in the past.
  • Higher valuation doesn’t automatically mean crash tomorrow but it means lower future returns. Investors need to adjust their investment plan accordingly.