All smoke, no fire: What’s behind recent equity market valuations?

December 20, 2017

All smoke, no fire: What’s behind recent equity market valuations?

December 8, 2017 | Lara Rhame | FS Investments

When valuations appear expensive, we assume there’s a fundamental reason for it. Where there’s smoke, there must be fire, right? This goes back to financial market basics – that markets are efficient and equity prices take into account all current and expected value. So what is the reason for this relentless march higher of equity valuations?

In this case, we see “smoke” (in the form of stratospheric equity valuations), so there must be “fire” (a resoundingly positive reason why stocks are pricing as they are). The fire could include stronger growth, a more robust economy, an acceleration in productivity growth, or signs of an upswing in earnings or profits, now or in the future.

I counter with a different argument. Right now there’s no fire raging under all this smoke. What we can observe is a series of short-term trends behind stocks’ soaring valuations. Some could have a short-lived positive impact on earnings. Some could be little more than headline distractions. The primary observable long-term trend that closely ties with higher equity prices is the multi-year surge in liquidity from lax global monetary policy.

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