It’s the Discount Rate
The current low interest rate environment increases the discounted present value of future cash flows and reduces the return demanded for every investment. In other words, when the Fed funds rate is zero, 6% bonds become disproportionately attractive. Buyers have now bid bond prices up until yields are now significantly less. In fact, 97% of outstanding bonds yield less than 5% today, and 80% yield less than 1%. Fed buying creates significant demand and drives up the price of financial assets, putting substantial liquidity into the market as sellers take advantage of these price increases. Then, those sellers buy other assets, driving demand for securities even further, elevating prices.
What does it mean if the prices of stocks and listed credit instruments are at levels not driven primarily by fundamentals reasons (i.e. current earnings and the outlook for future growth), but in large part because of the Fed’s buying, it’s injection of liquidity, and the resultant low cost of capital and the market’s lower demanded returns on financial instruments?
The Edge of a Spiral — Virtual or Disastrous?
If high asset prices are substantially the result of these technical factors, doesn’t mean that those actions must be continued for asset prices to remain high and that if the Fed reduces its activity, those prices will fall? Can the Fed keep it up forever? What are the limits on its ability to create bank reserves, purchase assets, and expand its balance sheet? What are the limits on Treasury’s willingness to run deficits, considering this year’s deficit is now at $4 trillion, and Treasury’s inclination to go well beyond that?
According to some former members of the Board of Governors of the US Federal Reserve:
There is no limit on the ability of a central bank to create reserves if someone is willing — or through government edicts, forced — to take those reserves. This was true in the extreme circumstances of Germany in the 1920s, Brazil in the 1970s, and it is happening in Zimbabwe today. But it is also happening in Japan — a well-governed country and a more benign situation. The key question is the impact of that reserve creation on money supply and the demand for money. Treasury’s appetite for deficit financing will remain high if real and nominal interest rates remain low.
In the last five months, the Fed has increased its balance sheet by $3 trillion and Treasury has added $3 trillion to the deficit, for a $6 trillion total increase of liquidity in the economy — with probably more to come. It’s normal to assume that an increase in liquidity on that order increases the demand for goods relative to the supply, bringing on increased inflation. This has already happened for financial assets. However, even with interest rates low for a decade and near zero today, inflation hasn’t come close to the Fed’s target of 2% (also the ECB’s and Japan’s Central Bank target).
Now, About Inflation
Regarding inflation, I think this is the key point: whether it is Japan, where the Bank of Japan’s balance sheet exceeds 100% of GDP and continues to grow rapidly, or the ECB with a balance sheet of more than 50% of eurozone GDP and growing, or the Fed with a balance sheet of just over 33% of US GDP and growing, inflation has been below the 2% target for an extended period, and expectations of inflation over both the short-term and long-term remain low. Even when the US was growing at approximately 3% annually prior to the pandemic, we didn’t see an uptick in inflation or inflation expectations. If there continues to be a very large demand for very liquid safe assets, like bank reserves and cash, the central banks can maintain large balance sheets, and even increase them, without a sharp increase in the money supply that ignites inflation. The ongoing uncertainty over the course of the virus and the policy responses will undoubtedly keep the demand for safe liquid assets high for some time to come. Inflation drivers are not currently present, and the expectation is that will not develop any time soon.
And the Dollar?
This monetary expansion can lead to a weaker dollar, higher interest costs on the national debt and perhaps jeopardize the dollar’s status as the world’s reserve currency. Since March, when the Fed and Treasury programs were announced, the dollar has depreciated almost 10% versus a basket of currencies. The dollar does tend to benefit from a flight to quality, and reached its height in March, and receded from there. But the dollar is still down 3% for the year and has been particularly weak recently.
Monetary theory is challenging here because countries like Argentina and Zimbabwe show that unlimited government liquidity and spending leads to disaster. However, credible governments like Japan and the US borrow enormous amounts without much concern. But what can undermine that credibility? There is a tipping point at which dramatic consequences can happen quickly — but where is it? It is not on anyone’s horizon, and Japan has shown that there is long-lasting credibility for its government when borrowing such large balances and injecting those balances into its economy.
One thing is clear: many investors have underestimated the impact of low rates on valuations. For equities, the earnings yield: the ratio of earnings to price (the P/E ratio inverted) should be about 4%, calculated as follows: treasuries yield less than 1%, and adding an equity premium brings the yield to approximately 4%. That yield (4 /100) suggests a market P/E ratio of 25. Therefore, the S&P 500 is trading below this multiple by roughly 50%.
Even this ignores a company’s growth. If earnings yield an additional 2% growth rate, then the actual market yield should be closer to 2% (which is a P/E ratio of 50). On this simplistic basis, stocks may have a long way to go. On top of that, market-leading tech companies continue to grow substantially and, with the current crisis, have been more pervasive in everyday life. The current situation has accelerated their growth and given them the opportunity to demonstrate they can grow regardless of environment and conditions. Their scale, technological advantages, and network effects give them much greater protection against competition. Even though they sell at high valuations relative to earnings, they are in “closed loops” that feed value to customers and customers feeding value back to them. Essentially, they have monopolistic economics.
Five Stocks Do Not Make a Market
Apple, Amazon, Microsoft, Google, and Facebook make up a disproportionate amount of the S&P 500 and are up an average of 36% so far this year, while the median change of all S&P 500 stocks is -11%. There isn’t really a market so much as these five large technology companies and everybody else. Continued bullish arguments for these five are credible, but, how sustainable is less certain. There are no events on the horizon that point otherwise, however.
This Time It’s Different, and Other Lies We Tell Ourselves
Currently, we have a surprisingly rapid recovery of the stock and credit markets to all-time highs in spite of the pandemic and that it will take many months for the economy merely to return to its 2019 level, and probably even longer for earnings to rise to a level that justifies the market highs. P/E ratios are usually high and debt yields are at unprecedented lows. Extreme valuations like these are usually rationalized by saying “this time it’s different” — and that usually leads to disaster. However, one of my mentors, John Templeton, said that things really are different about 20% of the time (as evidenced by his success investing in Japan in the 1960s, Taiwan in the 1970s, Korea in the 1980s, and in China in the 1990s — unusual circumstances can create almost logic-defying opportunities). In areas like technology and digital business models, things really are different often enough to see what could be a logic-defying trend. It can certainly be argued that today’s technology companies enjoy larger and more sustainable competitive advantages that we probably have not seen previously, and the “closed-loop” virtuous circles of their business models will bring rapid growth for decades, justifying valuations well past current norms. Today’s ultra-low interest rates further justify unusually high valuations, and interest rates are unlikely to rise anytime soon.
We Have Seen This Before
Even the best companies can be overpriced. I spoke about the “nifty 50” in my lectures, and these “can’t miss” companies, like IBM and Xerox, were expected to outgrow all other companies and defy competition and economic cycles. From 1968 to 1973, stockholders in these equities lost almost all their money.
My conclusions are limited by inadequate foresight and influenced by my optimistic and pessimistic biases. Experience teaches it is hard to get the answer right. Or, as Charlie Munger has said, “it’s not supposed to be easy. Anyone who finds it easy is stupid.”
At the risk of being stupid, equity investments in companies, including the five largest, with the unique competitive positions and “closed-loop” business models will remain excellent investments. In addition, certain fixed income securities paying high yields with attractive long-term risk-adjusted safety are extremely attractive and are being ignored in this unique interest-rate environment. This combination will create substantial value.
Unique macro forces created by the central banks, unprecedented and sustainably low interest rates combined with pandemic-tested sustainable business models have created truly unique opportunities.