FA Alpha Daily

Illusion of perfect pricing may break soon

Beneath the surface of a resilient 2023 stock market, Bob Jensen of Bridgewater Associates sees a brewing storm. Investor confidence, shaken by soaring interest rates and record highs, grapples with an uncertain reality: is the economy thriving or merely clinging on? In today’s FA Alpha, we dig into Jensen’s warnings and insights on the state of the stock market.

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Bob Jensen, co-chief investment officer of Bridgewater Associates, recently shared his insights at the World Economic Forum in Davos, shedding light on the perplexing state of the stock market.

In the aftermath of 2023’s volatile economic environment, where interest rates soared and stock indexes hit unprecedented highs, investor confidence is wavering.

The market’s resilience is admirable, yet it’s shadowed by uncertainty about whether the economy is truly thriving or merely surviving.

Jensen concurs with the market’s uncertainty, suggesting an inevitable shift is on the horizon.

Post the substantial stock rally of the previous year, the market appears to be anticipating a drop in inflation to the Federal Reserve’s 2% target, sidestepping a potential recession. However, as Jensen puts it, this “perfect scenario” pricing poses both an impressive feat and a brewing concern.

The primary issue lies in the market valuations.

The current levels suggest limited headroom for further growth, pointing to a situation where investors might have outpaced the market’s realistic potential. Jensen warns of the consequences of such over-optimism.

To understand this case, we turn to historical data spanning over a century. It reveals a pattern of investors consistently overestimating market potential in similar economic environments.

Notably, even during geopolitical tensions like the Israel-Hamas conflict and heightened recession risks, the S&P 500 displayed remarkable resilience.

However, this has led to a skewed perception among investors, who now seem to overlook the critical factors of inflation and tax rates that historically drive market valuations.

Over the last hundred-plus years, there’s been a strong relationship between inflation, tax rates, and valuations.

When taxes and inflation rates are lower, the market tends to trade at higher price-to-earnings (P/E) multiples.

You can see by looking at the chart below, which shows the market’s average P/E ratio under different tax and inflation environments since 1914.

In an environment like today, where tax rates are low by historical standards, and inflation is back below 4%, the market values at an average P/E ratio of around 20.1 times.

Take a look…

That’s why generally speaking we say the market average is around 20 times. And even if we look at the row in the chart with inflation expected to be less than zero with a low tax rate, the market had an average P/E ratio of 22.3 times.

But now the corporate average is 25 times. Not only is this more expensive than the conditions that the market is pricing in, but it is one of the highest average valuations we have seen in any circumstances.

The market is priced in a way that believes we are going to have inflation approaching 0% with continuously low tax rates for the next decade… an unlikely scenario.

As mentioned earlier, geopolitical issues have and will play a role in U.S. assets more than consumers currently believe.

Jensen’s point is that at a 25 times valuation, investors are acting like nothing is going to go wrong in the U.S. economy. But as more companies start going bankrupt, that dream is going to disappear quickly.

When the market is priced so high, it is tough to find value opportunities for investors. And not only that, but many expensive stocks have nowhere to go but down.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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