By Shawn Tully
February 5, 2018

Tony James, a renowned private equity investor, presented a highly contrarian, sharply negative view on the stock market on CNBC on Monday. His call has already set the Internet abuzz, but it’s worth a closer look. It’s the kind of analysis you seldom hear on TV business shows, where the coverage is dominated by Wall Street analysts, traders and market strategists who are relentlessly upbeat. And it’s exactly the tough talk that investors need to hear.

On Monday morning James, the president and COO of Blackstone, appeared on CNBC’s early morning show Squawk Box. He was there chiefly to discuss his new book, which advocates policies encouraging workers to save for retirement. Inevitably, the hosts asked James for his perspective on the big selloff that began the previous week. In just two minutes and 12 seconds of discussion on the markets, James made several crucial points explaining why widely accepted justifications for today’s lofty prices, and forecasts of big gains to come, amount to wishful thinking.

Stocks are overvalued

Asked, “Are you saying the stock market is overvalued?” James replied, “Yes,” then proceeded to shock anchors Becky Quick and Andrew Ross Sorkin and guest host Kevin O’Leary by warning, “We could easily see a 10% to 20% correction at some time this year.”

Why are shares so overpriced and vulnerable to a steep fall? “If you ask people [about stocks], they don’t make the case that stocks are fairly valued,” said James. “They make the case that if you want any return, it’s the only place to go.” An anchor then expressed the conventional view that since interest rates have remained extremely low for years, stocks–even at high prices–look like the only alternative offering decent returns.

Rates may spike soon

Clearly, James isn’t buying the “only-place-to-go” argument. To understand why, let’s step back for a moment. The returns investors expect for owning equities depend on two factors: The inflation-adjusted rate on risk-free bonds that compete with stocks; and what’s known as the equity risk premium (ERP), the extra margin that folks demand–over and above the yield on Treasuries–to compensate for the uncertainty of holding stocks. If the real rate and the ERP rise substantially, equity prices are likely to fall, since in effect, investors are applying a much higher discount rate to future earnings.

James cautioned that rates may soon jump. “The economy has been picking up for a while,” he said. “If you’re worried about interest rates and inflation, the stimulus [from the new tax cuts] could be the thing that tips us over to a rate spike.” The yield on the 10-year Treasury has already surged to 2.8%, a four-year high. James is essentially saying that rising real rates will undermine today’s giant valuations. He might have added that when markets turn volatile–and they just did–investors are going to demand a much higher ERP to own stocks.

In reality, the present-day bull case relies on the assumption that today’s slender real rates and the narrow extra margin stocks offer versus bonds are a permanent fixture. They’re not; both real rates and the ERP are constantly changing. And they’re headed just one way, up, pushing stock prices in the opposite direction.

The bulls are betting too much on the tax cut

Stock prices got another big boost after Congress enacted a huge package of corporate tax cuts in December. But James argues that much of the initial bounty from the sharp reduction in corporate taxes could flow not to profits, but to new spending. In other words, companies could quickly compete away the early extra profits flowing from the reduction in rates from 35% to 21%. That could (and should) be helpful to the economy, but it won’t necessarily boost shareholders.

“One thing I think the market is over-estimating is the amount of added earnings that the tax cut will bring,” said James. “One of the things that lots of executive are talking about is how much of the tax cut goes to shareholders, how much of it goes to R&D, to higher wages. The market’s thinking it all goes to earnings.”

It won’t. The most likely outcome: the cuts encourage companies to invest and expand because the rates of return on new investment will rise. A lot more investments will look profitable at 21% than at 35%. But to grow, companies will need to invest heavily in plants, patents and acquisitions, and in the process spend a lot more on workers, R&D and customer service. As costs rise, returns on capital will return to normal levels. Taxes are a cost, and if everyone’s costs in an given industry suddenly fall, the benefits will mostly flow to consumers and workers. It’s a Wall Street myth that lower corporate taxes herald a new era of sumptuous profitability.

Shocking warning, or common sense?

Stock prices have tumbled by 4% from the highs of late January. If the S&P 500 drops by another 16%, the high end of James’s prediction, the index would retreat to 2300. All the gains of the past 12 months would vanish.

A 20% decline would lower the P/E on the S&P 500 from it’s current, highly elevated status of over 24 to 19, around its average since 1990. Stocks still wouldn’t be a screaming buy, because earnings are near historic peaks, meaning that the denominator, the “E,” is inflated. So even under James’s most dire scenario, stocks would remain expensive.

For the bulls, listening to James is like getting doused in ice water. Complacent investors should welcome the jolt and heed his warning. In the contest of Tony James versus Wall Street group-think, James is the clear winner.


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