GMO Quarterly Letter | 2Q 2017

Why Are Stock Market Prices So High?

Executive Summary

  • Contrary to theory, the market P/E level does not primarily reflect future prospects. It reflects current conditions.
  • The variables it weights heavily are not academically or economically correct, but those that make investors feel comfortable.
  • High profit margins and stable, low inflation dominate this feel-good list, with stability of GDP growth (as opposed to actual growth) a distant third.
  • Investors’ extreme preference for comfort, like human nature, has never changed. (Tested back to 1925.) This is unlike financial and economic conditions, which have very substantially changed in the last 20 years.
  • The ebb and flow of these variables explain previous market peaks and troughs. These comfort factors, for example, have been at an extremely high average level for 20 years (as have P/Es) and remain so today. Thus today’s high priced market is the completely usual response from investors.
  • Any shift back to a lower P/E regime must therefore be accompanied by a major sustained fall in margins or a sustained rise in inflation (or both).
  • And, yes, I do believe these comfort variables will move to be less favorable. But probably not quickly.

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