Figuring out the fair value of a stock is an inexact science and at least one expert concludes that it would take six decades for stocks to reach that point if real interest rates remain where they are now.
Market strategists, portfolio managers and ordinary investors traditionally decide equity asset allocations by looking at the expected relative return of stocks over cash and bonds. But in order to do that they need to have a view about future interest rates, adjusted for inflation, especially the risk-free cash rate, and that is almost impossible to do, according to James Montier, a member of the asset allocation team at GMO, the global investment management firm.
"No one truly knows what the future real rate will be [and] it would be dangerous to build an approach to asset priced based on something very uncertain," Montier writes in his latest white paper, The Idolatry of Interest Rates Part II: Financial Heresy. "Yet an approach that puts the real cash rate at its very heart is surprisingly common."
Some researchers like Shane Shepherd of Research Affiliates, whom Montier quotes, gauge stock and bond returns against the equilibrium real rate of interest, which former Fed Chairman Ben Bernanke defines as the real interest rate consistent with full employment of labor and capital resources. "This is the intellectual equivalent of building on quicksand," writes Montier. (Needless to say Montier is not a fan of the ERIR, see ThinkAdvisor's story on his first installment of The Idolatry of Interest Rates GMO: Monetary Policy Is 'The Greatest Con Ever Perpetuated').
Others focus on the expected excess return of stocks over the risk free cash rate, known as the equity risk premia (ERP). "This is … akin to taking a glass of water (the likely return on equities) and adding some mud (the interest rate) and then finding one's self with a glass of muddy water," says Montier.
The problem is not that cash rates don't matter when valuing equities, it's that "we can't really tell what the real rate will be in a range that matters for our investments," says Montier.
