What are Stocks Worth?

Over the ten days between January 29 and February 8, the world’s stock markets  decided that equities were actually worth about 10% less than they were at the close on January 26. Of course, on that date markets priced equities more than 20% higher than they were immediately before Trump’s election. So prices have varied plus-or-minus about 25%, as shown in the chart of the S&P 500 below.

SP500 Election - Feb18

In terms of market history, there is nothing unusual about the recent price action. On Thursday February 8 we had the largest-ever single-day point decline in the Dow Jones Industrial Average, but nowhere close to the greatest percentage decline. At the end of trading on Thursday, February 8 we were officially in a correction, defined as a 10% decline from a prior market close. Since the Second World War, the US stock market has seen a correction about every 14 months. Nothing much to see here, then, in terms of unusual market action. But there may be an opportunity for increased understanding in examining the stated reasons for the decline.

The main driver of the decline was a rise in inflation fears. About one-third of the commentators noted that higher inflation will cause the Fed to raise interest rates, and those elevated rates will choke off economic growth, thus the decline has a legitimate economic basis. Another third of observers agree that the fear of inflation is causing a fear of rising rates, but think both fears are premature, and should not distract us from the current bullish reality–a strong world economy and a solid near-term corporate earnings forecast.

Both the bull and bear cases are based on the theory that economic growth drives stock prices. That theory is mostly wrong. To understand this, consider the stock market’s performance during the Obama years. By all accounts, economic growth during the years 2009-2016 was slow, especially after a deep recession. Yet the US stock market was up about 300% during Obama’s watch.

Here’s my take on the drivers of valuation:

Growth in GDP is almost irrelevant, unless the economy collapses into recession. More directly consequential is…

Growth in corporate earnings, which has been much stronger than overall economic growth, as corporations have used pricing power in labor markets to increase their margins. Corporate earnings are at unprecedented levels as a fraction of GDP. Earnings are the denominator in the pricing calculation, but the future streams of earnings and dividends we buy as stock investors are actually less important than…

The price we pay for them. There are three principal determinants of the price/earnings ratio. The least important is…

The prospective returns on competing investments. If Treasury bond yields were to rise to 6.5%, utility stocks (for example) would need to decline in price to remain competitive. This mechanism (direct and immediate competition for investor dollars) is way more important than the delayed, indirect, and hypothetical effect of higher interest rates on future economic growth, but still less important than…

Sentiment. Greed can drive markets upward much further and faster than any underlying change in the real economy, while fear can crater prices out of all proportion to actual economic declines. Earlier this month, stock prices fell by 10% in less than a week, but the US economy hasn’t seen a year-over-year decline in GDP of 10% since the 1930s. Sentiment-driven pricing changes can be abrupt and significant, but they are not structural. Which brings us to the most powerful driver of stock valuations…

Inflation. Contrary to the discussion in recent weeks, inflation is not an indirect driver of future earnings, mediated by the long-term effects of Fed policy on the availability and price of credit, and relevant only once it eventually results in changes in economic growth rates. In reality, inflation is the most direct component of the price we are willing to pay for future earnings.

Consider a company with $5.00 per share of future earnings. Assume the earnings grow by 5% per year. Within ten years, the EPS will be $8.14. (In the long run, growth in earnings that handily outpaces growth in GDP is nice work if you can get it, but that is a subject for another post.) In an environment of low inflation and corresponding low intermediate-term interest rates, prospective earnings a decade away can have substantial current value.

But what if inflation were 10% a year? In that case, those future earnings would be worth much, much less. Higher inflation makes future cash flows less valuable for two reasons–first, because the future dollars we’ll receive will be worth much less when we get them, and second because a high-inflation environment is more essentially uncertain and unstable. If I lack confidence in the magnitude of future benefits, I will give greater weight to current availability. I’ll have my dessert right now, thank you, rather than wait for something better tomorrow evening.

Corporate earnings, measured by the S&P 500, have grown from $13.30 in 1979, when I started work as a stockbroker, to over $105 today. That is an increase of just over 8:1. But the price of the S&P? That has gone up by more than 25:1. The price we are willing to pay for each $1.00 of earnings has tripled over almost forty years. That rising tide has lifted almost all boats, so much so that the inflation-adjusted trailing price/earnings ratio we pay for the median stock in the S&P 500 was recently the highest ever.

Over the decades since the cyclical market low of August 19, 1982, the principal driver of rising stock prices has been falling inflation. For 90% of my career, starting in 1981, the inflation rate has either been declining or low and static. Most people working in the financial sector have never worked during a rising inflation environment. Quite a few have never actually experienced a bear market.

If inflation picks up, we won’t need to wait for a delayed and indirect effect on GDP growth and corporate earnings some years in the future. The effects will be felt much more quickly, as markets rediscover the pain of a less valuable future, manifested in the form of a lower structural P/E ratio.

What should we do about all of this? Two things. First, operate from a more-informed understanding of the true potential risks, which are about much more than hypothetical economic growth years from today. Our stock and bond portfolios contemplate higher inflation, along with other risks. Second, diversify internationally. Higher inflation in the US does not necessarily imply higher inflation worldwide.



The China Syndrome

Twice within the first week’s trading in 2016, Chinese stock markets were halted by a 7% “circuit breaker” designed to pause trading to allow panic selling to calm. When it became clear that denying investors liquidity for their shares was feeding panic, not calming it, Chinese officials wisely suspended the circuit breaker yesterday, on Thursday, January 7, 2016. Friday, Chinese markets inched higher, and most world markets followed.

China’s market problems immediately spread to the rest of the world. Here in the U.S., we had the worst first four days of trading in a new year since 1950. (Both 2008 and 1991 saw sharper declines, though they took five and six days respectively.) Those first four days alone officially qualify as a market correction for both the Dow and the NASDAQ, though not for the S&P 500.

There are several lessons here:

For years, there has been a disconnect between financial markets and the real economy, driven by monetary stimulus and access to easy credit. Rising stock prices became the self-fulfilling justification for further rises, largely decoupled from economic fundamentals. China’s problems with bad debts and malinvestment have been visible for five years or more, but the Chinese stock market continued to rise, finally peaking in June of 2015 after an astonishing 150% over seven months.

Though the combination of public and private borrowing, combined with cheap and easy money, can drive speculative excesses for shockingly long periods, they cannot do so indefinitely. In China, in Japan, in Brazil and Greece, we see again and again the ultimate consequences of stupid public- and private-sector investments fueled by borrowed funds. (Put another way, both Tom Friedman and Paul Krugman are idiots, though Krugman’s idiocy is fueled by ideology, not genuine stupidity.)

A heavily indebted world awash in cheap money is unable to generate sustained economic growth at a pace sufficient to lift incomes. More debts and more liquidity will not solve a problem caused by the destruction of both financial prudence and the possibility of rational price discovery. Durable prosperity depends on the action of free markets, with capital flowing toward projects with the highest economic returns. Empty, roofless cities in China, a train to nowhere in California, billions diverted to the private pockets of public officials in Brazil–none of these can provide a solution to stagnant global growth, but all can absorb capital, attention, and human creativity that would earn much higher rewards chasing genuine progress.

To return to robust global growth, we need a return to more normal interest rates and a reduction in the size and regulatory scope of government. (Who in the U.S. political system understands this? Certainly Fiorina, probably Paul and Cruz, perhaps Kasich and Rubio. Clinton? Surely not Trump or Sanders.)

Enough economic commentary. What are the implications of China’s meltdown for investment strategy?

For much of the last two years, our portfolio strategy has been defensive while U.S. stock prices (at least through mid-2015) continued to advance, with that advance highly concentrated in speculative tech stocks. We under-performed. Now that markets are falling sharply, our diversified, cash-heavy portfolios are holding value better than stocks in general.

We live in an interconnected global economy. That means there is no safe place to hide, while still earning positive real returns. (In a low-inflation world, you can hide in cash, but it surely will not provide returns sufficient to buy lunch, gas up the car, or put a roof over your head.) Here is the good news: globalization also means we have the ability to flow capital toward areas of genuine economic opportunity, across national borders, and between industries and asset classes.

There is a fundamental difference between 2007 (the market peak before the 2008 financial crisis) and today. Back then, nothing was either absolutely or relatively cheap. Today, there are huge divergences from historical price relationships, particularly between growth and value (value is cheaper than at any time since 1929, with the exceptions of 1998 and 1999), and between U.S. and foreign stocks. (U.S. stocks are more expensive than foreign developed-market stocks by a larger margin than we’ve ever observed, going back to the creation of the MSCI EAFE Index in 1969.)

Our long-term strategy remains the same. Avoid permanent impairment of capital; don’t own stupid, over-priced assets. Own more of those quality assets that are cheap according to robust historical measures. If the market crashes and they get really cheap, buy more.