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“What goes up, must come down”

August 31, 2015

It’s been quite awhile since I have blogged about the state of the economy and investments in general. While my last blog was not exactly prophetic (i.e. about two years ago, I worried about the overvaluation of the stock market and the general artificial asset inflation that had been driven by the Fed’s massive money printing), I believe with the high volatility in the market of the past couple of weeks, including some very scary drops in the Dow and S&P indices, that the stock market may be set to fall significantly and even crash in the not-too-distant future.

So why worry? After all, the US economy after a very tepid recovery (the worst economic recovery from a recession in the last 70 years) has shown some signs of growth, with a recently revised 3.7 % growth in GDP in the second quarter. Further, though China’s economic growth has slowed, it is still growing at 5% or so a year (according to most economists, though the official “cooked” Chinese numbers remain at 7%). So the large correction in the market of the past two weeks was clearly an overreaction. Right?

Perhaps, but the stock market’s valuation is high given continuation of current growth trends and current interest rates, and unusually high given the prospects of slow or flat earnings growth and likely significantly higher interest rates in the next few years. To quote Al Gore, consider the following inconvenient truths:

  • S&P earnings per share and profit margins are at or near all time record highs, and are unsustainable. It is almost a certainty that profit margins will narrow and S&P earnings which have largely been flat over the past year will come under further pressure. Profit margins have grown since 2009 because companies cut back on overhead and other costs and became more efficient and adjusted to a lower demand world in the post-2008 period. Profit margins also grew because interest rates fell (due to the Fed) and companies refinanced their debt with much lower cost money resulting in lower interest costs. Earnings per share have grown even faster since 2009 because many S&P companies have bought back shares and have become much more “leveraged” ( i.e. more debt vs equity) because of the low-interest rates, which means profits are spread over fewer shares, automatically boosting earnings per share.
  • Economic growth, normally a key driver of corporate profits, has been tepid and seems unlikely to heat up in the long-term – The economy has grown only at about 2% per year for the last 3 years and only somewhat more since the beginning of the recovery in 2009, making it the worst post-recession economic expansion since before World War II. And though unemployment has fallen to lower levels, the key statistic of labor force participation is at lower levels than anytime since the 1970s. In fact, despite continuing growth in the overall working age population, the number of people employed is still less than it was in 2008. Further, the percentage of those jobs that are part-time rather than full-time has grown. In addition, median income has continue to decline in real inflation-adjusted terms since 2007. Lastly, demographic growth is largely turning negative as the baby boomers begin to retire in droves over the next few years, such that total employment and net disposable income (key drivers in our largely consumer driven economy) will come under increasing pressure.
  • The stock market’s rise has been driven largely by massive money printing by the Fed during 2009-2014. The Fed has QUINTUPLED the monetary base of the US to about $4 trillion from $0.8 trillion when Obama first took office in 2009. Of note is that late last year, the Fed stopped money printing and the stock market has moved up and down but is still more a less at the same level as it was last year. So why doesn’t the Fed print more money now? The reason is that the Fed fears that inflation will be ignited with rapidly rising interest rates and eventual economic contraction. Since there is a strong correlation in the LONG run between money printing and inflation, this fear is not without basis.  (NOTE: Why does money printing act to increase stock prices? When the Fed “prints money” thru its quantitative easing (QE) policies, it buys treasury bonds and bills from US investors or the Chinese or other treasury bond owners. This large increase in demand for treasuries increases their prices and thereby reduces interest rates. This makes stocks in particular much more attractive investments because of the artificially low-interest rates. It also means the former owners of the bonds now have more cash to invest in the market)
  • US Federal Debt remains a huge and growing problem in the long-term – The good news is that we have managed to get the deficit to a more manageable level of a “mere” $400 billion+ for this current fiscal year ending in September and we may (according to the CBO) be able to trim this a little bit further by end of FY 2016. The bad news is (1) we still have over $18 TRILLION in federal debt and (2) even using the overly optimistic assumptions by the CBO, this deficit and debt will again start to swell substantially beginning in 2017 and explode again by 2020 as many baby boomers retire. There is a good chance that we will likely see the unthinkable at this point, that the federal US government may have to default on its interest payments, barring MAJOR changes in our massive federal spending habits AND major cuts/tax increases/reform for social security and Medicare.
  • The value of the dollar has also been unusually strong over the last two years. This has the effect of making US goods more expensive (and already has started to hurt exports and foreign earnings for US companies). Also, this is in spite of the large amount of money printing which theoretically at least should make the dollar cheaper (i.e. more dollars chasing the same number of products). The dollar’s rise has been part of a virtuous cycle where a strengthening dollar has attracted foreign capital to the US stock market (and real estate market), which in turn strengthens the dollar further. The problem is if the stock market has a significant decline (due to some of the overvaluation fears triggered by an event such as lower earnings reports) this creates the opposite negative cycle, where lower stock prices result in fleeing foreign capital which reduces the dollar’s value and which further deflate stock prices.
  • Major declines in the dollar will help fuel inflation along with all the printed money as it is increasingly loaned out by the banks. The banks have kept very high levels of cash reserves at the Fed since 2009 reducing the “velocity” of all of the printed money and thereby delaying the inflationary effects. However, the banks have begun to increasingly loan out greater amounts as their financial health has improved and this alone may start to fuel inflation. In addition, declines in the dollar will result in inflation in the price of imported goods from other world markets, as well as the prices of almost all commodities.
  • More inflation and a declining dollar will force interest rates higher possibly to double-digit levels. At a certain point, the Fed won’t be able to control rates particularly as the market sinks significantly and the dollar falls in value and inflation heats up.

So what does this mean for stock prices and the stock market in general? As I blogged about two years ago, stock market valuation is primarily driven by a simple construct–the value of a company is equal to the discounted value of dividends received over the lifetime of the investment. In other words, if you buy Company X which provides you with a $2.00 per share dividend , and you project that the dividend will grow by 3 percent per year over a 40 year time horizon, then the value of the company stock will be all those future dividends discounted back to today using the risk-free interest rate ( which is typically equal the projected interest rate on intermediate-term US treasury bonds).  Thus, there are three main components that determine value of stocks and hence the price of stock market indices like the Dow Jones Industrials or S&P 500:

(1) current dividends per share paid

(2) projected long-term per annum growth rate in dividends paid per share

(3) the interest rate on a “risk free” instrument such as an intermediate-term treasury bond

For most companies and the S&P 500 as a whole, the best predictor of the future dividends growth rate is the earnings growth rate since dividends are generally paid out of earnings per share and the two have tended to grow at about the same rate over time. (e.g. during 1980-2013, SP-500 dividends per share have grown by 5.1% and earnings by 5.5% per annum).

Just like I did two years ago, in order to get a read on how the market is currently valuing/pricing the S&P 500, I used a simple spreadsheet to take the earnings and dividends of the S&P 500 and assumed various discount and growth rates. What I found was interesting to say the least, and a compelling picture as to why the market may be substantially overvalued. Using my spreadsheet model, and solving for the current S&P 500 price of 1941  implies a slower long term growth rate in dividends per share of about 3.2% per year (vs. the last 32 years 5.1%) , but also a continued very low 2% per year, long- term discount rate. Alternatively, it could imply a higher discount rate (3%) but also a faster 4.2% per year. However, there are several major problems with this implicit “market” assessment.

(1) Risk-Free “Treasury” Interest Rates/ Discount Rates are almost certain to rise substantially over the next few years. As I noted above, there are many factors (e.g. future dollar declines, inflationary pressures etc.) that suggest a large increase in interest rates is likely to come soon. Further, current interest rates are exceedingly low today with 10 year treasuries only a little bit above 2%. In fact, between 1966 and 2001, long-term, risk-free interest rates were almost always above 5 percent and for most years averaged between 6 and 8 percent . Thus, just moving back to more “normal” interest rates would be a huge rise from today’s 2% rates. However, we could easily see the situation become much worse than that and resemble the situation in the late 1970s and early 80s where we had long-term treasury rates between 8 and 16 percent!

(2) Dividends Per Share and Earnings Per Share are in a Short-Term “Bubble”. As discussed above, it seems unlikely that there will be much growth in earnings and dividends due to fundamental economy and demographic trends in the US. Further, the stock buybacks that help fuel the EPS and DPS growth are likely to be far less frequent in the future once interest rates start to rise. Further, corporate costs such as interest, health care costs, pension costs, and taxes are all expected to climb significantly. This is hardly a recipe for robust growth in earnings and dividend payouts. In the long run, inflation will increase the underlying costs of goods sold resulting in a profit margin squeeze as well.

(3) Long Term Economic Growth Will likely be Much Slower Affecting Long Term Earnings and Dividend Growth–The combination of negative demographics (e.g. aging of population affecting consumption patterns negatively as the baby boomers become lower consuming retirees), slow productivity growth, higher federal, state and local taxes and medical costs and slow US population growth, means that economic growth is likely to be signficantly lower than the 3% per year real GDP growth we’ve experienced over the past 3 decades. Notably, even with enormous monetary and fiscal stimulus over the past 4 years, we have only been able to grow US GDP by around 2%. In other words, we may be lucky to see 1-2% GDP growth over the next decade with all the headwinds noted above.

Bottom line: I ran my spreadsheet with more realistic dividend growth and interest/discount rates. Depending on my assumptions, I found the market was worth only about 30-60% of today’s levels. This isn’t to say that the market will crash 40-70% tomorrow. There are too many people who have a vested interest in talking the market up and keeping the participants optimistic. As long as market optimism remains relatively high and the Fed can keep interest rates down in the short-term (probably thru another round of money printing) , a major market fall can be delayed for another year or two. Ironically, another round of money printing should the market start to fall precipitously may be one way the Fed staves off a market fall in the near term. However, my advice to you is to avoid the future risks and at least cut back your stock holdings back significantly as a % of your overall investments. Maybe there is still another 10-20% upside left in the market and maybe the crash will be even held off indefinitely (of course, I could be wrong), but I wouldn’t advise waiting around to find out. After all, “what goes up, must come down”.

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