Debt and wealth in a monetary system, part 2: discounted valuation issues in a declining frame with inequalities.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

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Critical perspectives on US Market Valuations 2…includes 17 charts

Many say that lower interest rates should raise asset valuations by lowering the rate at which future income streams are discounted.  This may be fine for high quality government bonds where coupons are fixed, but is not necessarily the case for equities where we are dependent on future flows (earnings, dividends, economic growth, CAPEX). 

What is the major determinant of long term real equity returns?  Earnings growth, and long term earnings growth is dependent on real economic growth.  If we look at real growth rates they are falling, and have been falling for some time.  This is part of the reason why interest rates have been falling; that is to accommodate falls in nominal and ultimately real flows.

The following shows annualised annual growth rates over rolling 15 year time frames (in other words geometric returns) compared to the Shiller Cyclically Adjusted PE ratio:

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Share buybacks..quantitative easing, secular stagnation and the risks of Myopic Share Virus..

The point about share buybacks is that they sit uncomfortably in a widening narrative of increasing inequality, weak income growth (worse at lower income levels), falling economic growth rates and disturbing trends in both human and capital investment. The backdrop to the narrative and one that threatens to envelop it as one are the burgeoning asset and debt markets, whose rise is at odds with the weakening fundamental growth prospects of many developed economies. Asset markets and hence debt are being supported, yet the fundamental underpinning to their longer term valuation, investment and growth in real incomes is being weakened. At some point the two, economic reality and asset market capitalisation will need to meet.

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Weak demand dynamics and final Q4 US GDP

I was just looking through the GDP revisions: real growth was higher because a decline in the GDP deflator and nominal GDP fell from the last revision.  Nominal net exports also fell while health care expenditure was a significant upward revision.  

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My concern rests with the underlying growth rate of the US economy, especially domestic demand and the PCE component in particular.  I have referenced this issue before.

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GMO Quarterly

Just a thought, but with a few exceptions, there are not that many who are seriously questioning valuations relative to future potential growth rates.  But think about it, why would you create a rod for your own back?  If your job is to invest, then you may not wish to be hamstrung by valuation dilemmas.  Claim markets are overvalued and you have to do something about it.   I tend to be in the rod for your own back side of the room, but I can see an argument for claiming valuations are good, albeit one that has nothing to do with value.

Excerpts from the GMO Quarterly Letter:

as value managers listening for any assets, anywhere, that are screaming to be bought, the world currently sounds a deathly quiet place.

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Brief comments on Mckinsey “QE and ultra-low interest rates: Distributional effects and risks”

QE and ultra-low interest rates: Distributional effects and risks (McKinsey)

McKinsey state that QE does not appear to have affected equity prices.  In a sense, you could say that because most of the cash used to buy the bonds has remained on the Fed’s balance sheet, and because the supply of money itself has little impact on future real returns, and if investors and agents assume that QE itself will not directly impact economic activity then in a rationale world it is unlikely that QE would impact equity prices – equity prices being determined by the future real supply of returns.

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When two universes collide – the “Active Versus Passive” debate

Allocating to hedge funds for the ordinary individual and for most financial advisers/advisors is as easy as passing through the eye of the needle

In the passive active debate there is a duality, two universes living side by side.  And by this I mean we have those who say that active management is a zero sum game and worse when fees and transaction costs are taken into consideration.  On the other hand we have those who say that active management is not a zero sum game and that value can be added even after fees and transaction costs are taken into account.   Interestingly academics have taken both sides of the debate.

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Risk and Return Within the Stock Market: What Works Best?

From Risk and Return Within the Stock Market: What Works Best? By Roger G. Ibbotson, Ph.D. and Daniel Y.-J. Kim, Ph.D:

Contrary to theory, low beta and low volatility portfolios outperform high beta and high volatility portfolios……. Overall the best returning characteristics are high earning/price, high book to market, and low turnover. On risk adjusted basis, the best performances were low beta, low volatility, and low turnover……Within this anomaly, a common theme emerges. Whether it be through factors that encode popularity among investors (turnover, growth), academic popularity (citations), or popularity caused by leverage aversion (beta, volatility), popularity underperforms.

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Risk and return from the back of an envelope and….we may well have a bubble..

Quantitative easing is designed to bring forward asset returns before we get the economic returns, in the hope that the confidence and increased wealth generate demand in the real economy. By its very nature its objective is to create a bubble in asset class valuations in the hope that the bubble drives the real economy forward

It is possible that markets have got well ahead of themselves, and could well be in bubble territory. 

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Valuation Perspectives

John Hussman has been beating the drum (‘till his hands bleed…) about the risks of current market valuations in his weekly commentary

I think, supporting this message, it is worthwhile paying attention to historical relationships;  at the moment, while the water is pushed to one end of the bathtub, and the line is indeed high in this respect, it tells you little about how much water the bathtub actually holds and the relative stability of the dynamics.

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The reverse yield gap and the long bond/nominal GDP growth dynamic

Bond yields used to be lower than equity yields, and significantly so, up to the 1950s. The reversal of this relationship during the late 1950s, a reversal which peaked at the end of the 1990s, helped provide a significant revaluation of equities during this period.  Many a long term equity return expectation has been built upon the reversal of the original yield relationship.

The following charts use US data sourced from the Shiller/Yale dataset to highlight this input to historic equity returns and risk premium.

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And of course, the same goes for the more pronounced earnings yield relationship (Shiller/Yale source data): note the earnings yield/ten year bond yield ratio: Continue reading

“It’s time to reset your investment assumptions”..says the Globe and Mail. But is it, and should it be up or down?

Is it really time to reset your return assumptions downwards? A Rob Carrick articlein the Globe and Mail suggested that it might be so.

Revising return assumptions down after poor stock market returns is a Bete Noire of the financial services industry.  All other things being equal, and depending on your paradigm, you should be revising them up after a period of poor returns.

But you cannot revise upwards if your return assumptions were too high to start with. If you have relied on historical average returns or risk premiums to set return expectations you have also more than likely failed to adjust for cyclical and structural risks in markets and economies. Continue reading

What return assumptions can we expect going forward?

The major driver of stock market returns, all else being equal, is earnings growth, which while not totally equivalent to nominal GDP growth, tends to exhibit similar rates of growth. 

Gross revenue should more or less increase at the same rate as expenditure based GDP growth, even though earnings growth will differ due to changes in corporate taxes, depreciation factors, cost cutting and productivity factors.

From December 1966 to December 2011, real US earnings growth (source Shiller data) rose by some 1.85% per annum, while real GDP growth (BEA data) has been some 2.02% – all figures are geometric averages.   Nominal GDP growth had averaged 6.65%.   

Total real return, going forward, based on this data would be 1.85% per annum + the dividend yield (close to 2%).  So for say the US, if the future were to represent the past, we would expect non compounded real returns of 3.85% per annum: compound real returns would differ, but not everyone receives compound returns, especially those living off their assets.  Continue reading

Cutting Through the Noise!

The title comes from a Tom Bradley Steadyhand blog.   Tom makes some valid points: equities represent a buying opportunity when shares are as relatively under valued as they are now, and when it would appear no one wants to buy.

In other words, when others are selling and prices have fallen to historically cheap valuations, then ignore the fear and buy, because over time, once demand returns prices will recover, and if things get worse, then maybe we will not need to worry either way.

Equities based on historic price earnings ratios are cheap.  There is no doubt about that, and relative to bond yields, even more so.

A “buy low” when everyone is fearful approach is fine within an overall stable financial system, without the excesses built up over decades that we have.  But if we are about to enter a long period of debt deleveraging and declining final demand presaged by the potential collapse, however temporary, of components of the financial system, then the old adage of buying when everyone else is fearful may not necessarily hold to the same extent.  

As an investment discipline, this type of thinking has served marginal investors well, and I would suggest on average over time will continue to do so.   I am sure that those with very long investment time frames can still use present opportunities to buy shares that have not been as cheap for decades.   One can also easily argue, that today investors are buying at prices that will obviate the buying mistakes of the last 15 years or more, aside from the opportunities of 2009.

Bill Miller must have been thinking the same thing, like John Paulson of hedge fund fame, and similar comment to Tom’s have come from Fidelity’s Anthony Bolton (with respect to his China fund).  All these value focussed investors are of course correct in a sense: you should focus on the value, not on what could happen to make things worse, because of course you would not buy.  Things can always get worse, but more often than not, most of the time prices already discount the worse.  Unless of course, your scenarios are limited and based on past events.

But, I do think it worthwhile to consider the deep and peculiar circumstances in which we find ourselves.  Corporate profits are at all time highs in many markets, yet consumer demand, and its attendant structural imbalances, and output have been held together by fiscal stimulus and low interest rates, with the consequences of such now impacting sovereign debt markets and interest rates on debt, though not central bank rates. 

It is conceivable that we are entering into a deflationary period where overall demand declines: under such a scenario corporate profits and book value are exposed to significant rerating.  It is worth noting that most of a discounted cash flow valuation is derived from the first 10 years of cash flows, and it is precisely these ten years that are at risk from a debt induced deflationary economic environment.  

A small decline in real demand has a significant impact on profits: if profits, let us say, are 10% of National Income and National Income broadly equals GDP, and consumer demand is 70% of GDP, then a a 3% decline in domestic demand = a 21% decline in profitability, and more once we add in write offs to goodwill and other capital items.    If we start off with a P/E of 13, this would lead to a P/E of 16.5, and higher with write offs.   With austerity and debt reduction added to the mix we further reduce the GDP base, thereby further impacting profitability leading to further write offs.  

A deflationary episode is not covered by most bullish, or even value biased, assessments of stock market value, and while I am sympathetic to valuation arguments and contrarian discipline, I think the current environment far too complex to be able to simply refer to what are effectively behavioural benchmarks.   

Yes, value biased investors that do not incorporate detailed analysis of the impact of structural financial and economic imbalances on profits going forward are using behavioural benchmarks to determine investment behaviour: 1- herd behaviour to a certain level of significance.

The current financial infrastructure (debt, assets, government lending, employment, investment, final demand etc) that drives valuations is under risk of being rewritten and we need to assess the impact of the rewrite on valuations, at least, before we can express confidence in our dogma.