- The dependence on margins. One reason that stocks look reasonable is that, thanks to low interest rates and slow wage growth, margins are at historic highs. If rates or wages rise, margins will compress, driving earnings lower. This will make stocks look more expensive (this is why stocks look more expensive based on the Shiller P/E ratio, which implicitly assumes some mean reversion in margins).
- The extent to which low rates are propping up valuations. Low rates don’t just support margins, they also support multiples. With bonds offering no competition, stock valuations are higher than they would typically be in a slow-growth world.
In summary, today’s valuations are largely dependent upon the continuation of an unusual set of circumstances.
Where does this leave investors? Probably in the same position they were in back in August. Stocks can still move higher, assuming rates stay low and margins high. I’m assuming both…. for now.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.
Sources: Bloomberg