The case for why equity valuations may be reasonable

The case for why equity valuations may be reasonable

Market valuations appear elevated. The S&P 500 looks expensive. That’s the refrain when examined through traditional valuation metrics such as earnings multiples compared to long term S&P averages. There is valid argument why this is not the case.

If one assumes that interest rates will revert back to long term averages, market valuations look expensive. However one of the implicit assumption’s in the current valuation of the market is that interest rates will stay lower for longer. Simplistically, low long term interest rates see more demand for higher risk equity investment rather than lower risk, guaranteed bond alternatives.

An increase in interest rates sees a shift in investment dollars from stocks to bonds where investors can get lower risk, guaranteed return. Higher interest rates increase the required return that investors need to compensate them for holding equities as opposed to more guaranteed alternatives like bonds.

While market participants may disagree on the validity of that assumption my view is that there is a very good chance that interest-rates will remain at lower levels for an extended period of time. If that assumption is valid, then valuations don’t appear that troublesome.

Of course rates will gradually and steadily rise as economic activity picks up. I think one of the observations right now is the concerted global economic activity across the board. You’re seeing economies in Asia and Europe grow together in a coordinated fashion for the first time in more than a decade.

Emerging market growth continues to be a bright spot with respect to economic activity, with a potential real estate bubble in China and Chinese banking problems notwithstanding. US economic activity continues to be solid with the unemployment rate remaining at persistently low levels and the personal tax cuts that the government is instituting will likely lead to a pick up in consumer spending which invariably should be positive for the economy in general.

US corporations look set to make investments in their workforce and capital stock for the first time in quite some time. Each day seems to deliver a new hiring announcement by some corporation.

All of these reasons are positive indicators for a gradual and measured rising interest-rates. However, how likely we are to return to historic economic cycle high interest rates will ultimately be a function of inflationary pressures in the economy. Whats puzzled economists is why inflationary pressures have remained persistently low in spite of peak employment and strong economic growth.

In my mind however there is one major factor of significance that explains low levels of inflation and mitigates against interest-rate’s rising two levels that were the norm in in previous economic cycle highs.

That factor is the presence of technology. More specifically it is the sweeping role that artificial intelligence will play in the economy over the next decade. Technology generally is a positive force for productivity improvement for a corporation. However this trend is nothing new. Evidence of this has been seen for a number of decades in the automation of global manufacturing lines and plants for quite some time.

Automation has made possible the steady displacement of workers  in areas of the economy that have been reliant on manual labor. In recent years technology innovation has also enabled the displacement of more highly skilled labor performing tasks that require greater sophistication and human interaction.

Banking transactions are now more frequently automated,  checks cannot be deposited via application  or ATM. Customer service interactions can be handled by a software interface. You tax return is more likely to be handled by software.  However this is just the tip of the iceberg. Artificial intelligence will likely extend this paradigm to enable both unskilled and more highly skilled labor to be displaced.

Retail, which is a large employer of labor will see even more profound changes. The Amazon store of the future where customers ‘check themselves out’ will see less need for labor at the checkout. The packers and retail workers that you see stocking shelves? The odds are fairly good that  in a few years you’ll have robots doing most of that manual work. Package delivery and drivers? Will these even be occupations that exist in 10 years time? Autonomous vehicles are already a reality. The combination of the two could put large chunks of the workforce out of employment.

The far more scary prospect is the wholesale automation of tasks that require some element of decision making and analysis. In many corporations you have hordes of people focused on  activities including data gathering, data preparation and data analysis. Data preparation and financial reporting is something that’s just as likely to be done by sophisticated machines than finance clerks.

Complex interpretation of sophisticated images will be performed by sophisticated machine learning algorithms and computationally intense GPUs. So the radiologist interpreting complex images is just as likely to be a machine from IBM named Watson as it is a human. This will have profound implications across areas as diverse as radiography, medical analysis and retail marketing.  Occupational functions that interpret data will increasingly have their judgement farmed out to machines.

So what does any of this have to do with interest-rates and valuations? The first of these is that with the increase in abundance of alternatives to labor the ability of individuals to generally bargain for higher wages is more limited.

Technology and AI will hit lower skilled workers particularly hard. If the machine can do a task just as well as a human can, then the human is less likely to see wage increases. That alone will make workers more reluctant to seek wage increases. The other implication of artificial intelligence is that the labor capacity constraints that come with full employment are also likely to be reduced. That will not only result in productivity improvements but also mean that competition for scarce resources will be limited. Even more likely is the steady displacement of labor to capital.

Capital costs uniformly are decreasing. Chips are getting more powerful. Huge demand is resulting in economies of scale that continues to drop chip prices steadily lower.

Now of course these trends will play themselves out over several years. However they will likely mean that while interest-rate will show gradual increases from historic lows, they can remain at lower levels for longer because they traditional forces that cause rates to rise (typically overheating of economy due to limited labor supply) will be reduced.  That will intern have profound implications on equity valuation’s and the shift of wealth from labor to stockholders.

While no doubt a development with immense social implications, this is a development that long time investors would be well advised to monitor.


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