Last week a few additional prominent names surfaced as equity bears.  The impressive list now includes: Soros, Gundlach, Icahn, Tepper, Druckenmiller, and Gross.  Some of them have been short since earlier in the year.  Ouch.  Most people would look at the list and say, “Wow.  All these smart and experienced folks saying the same thing.  I need to get out.”  That would not be me.  Because when “everyone” (especially the larger players) seems to be in the same boat and the price action couldn’t care less, that should be considered a bad sign.  Equities keep grinding higher and the VIX keep grinding lower.

I had previously discussed the (Baby Boomer) elephant and why all assets will be pressured higher.  This does not mean assets couldn’t go down, but there is natural support for assets.  One of the interesting implications is that once that huge cohort starts becoming net spenders (rather than net savers/investors) we could get an asset collapse.  So I am somewhat in agreement with those folks.  I’m just not sure the timing is right.  It reminds me of 1999 when everyone said the Nasdaq at 2500 was too high and just a year later it got to over 5000.  It could be a while before we stop being in an investment grab environment.

Let me give you some vignettes on relative value right now in the markets:

  • If you had to own ten year government notes, which looks the most attractive: (1) US treasuries at 1.58%, (2) German bunds @ -0.03%, or (3) Japanese JGBs @ -0.08%. Take your time… I know this is tough.  It’s funny some global central banks are having a problem buying bonds in this low rate environment.  In any event, you really can’t say US treasuries are crazy rich when compared to other bonds.  Even Williams’ neutral rate model shows less than a 100bp difference between the US and EU (see chart on previous page).
  • Speaking of negative yields, consider this theoretical question: what is the value of a perpetuity in a zero (or negative) rate environment? Yep… infinity.  If an entity is solid enough, dividends could be considered an (increasing) perpetuity.
  • jnj-dividend2_largeConsider Johnson & Johnson stock. It has a dividend yield of 2.4%.  They even increased their dividend through the Great Recession.  This is over 80bps higher than US ten year treasuries.  J&J also happens to have an AAA credit rating.  The US government has a credit rating of AA+.  So a higher credit entity offers a 50+% higher yield, and somehow people are making the argument that the class of investment that the higher credit entity is in is somehow massively overvalued?  If you are a retiree with a choice between: (1) US ten year notes at 1.58%, (2) J&J ten year notes at 2.05% or (3) J&J stock with a dividend yield of 2.4%, which would you pick?  You need to factor something in for the US being able to print money, but I don’t see equities being overvalued.

It seems to me that most people’s metric for assessing equity valuation is based on two things: (1) some function of a P/E ratio, and (2) some function of recent declining earnings.  These can be reasonable relative metrics – over a short and “all other things being equal” comparison period.  “All other things being equal,” the higher the price to earnings ratio, the richer the stock may be.  Similarly, if the earnings of a company are lower, “all other things being equal,” the lower the stock price should be.  But are “all other things equal?”

Consider this following example.  Let’s say you pay $5,000 a month on a (30 year fixed) mortgage.  Based on past couple of decades, you could assume the house was worth around $834K (assuming a 6% historical mortgage, and the “P/E”[1] would be 13.9).  If the house is worth $1.1 million (“P/E” = 18.3), the house could look like it is above fair value.  If the house is worth $600K (“P/E” = 10), the house could look like it is below fair value.  Is this really how you look at the value of a house?  Aren’t you missing something MAJOR when looking at the housing market this way?  But this is basically what people who look at P/E are doing.

yellen-fig2-20151202The main reason the historical price-earnings ratio made sense as a reference point in the past is that the longer term discount rate (some function of the neutral rate) was somewhat stable.  Even in 2002-4, when FF rates were low (they eventually got to 1%), the longer term theoretical rates didn’t change much because the Fed easing was considered “temporary.”  See the chart from a Yellen speech last year, where the real neutral rate has been somewhat stable before the Great Recession.[2]  If you wanted to use some kind of simplification like a P/E ratio, that was reasonable across a couple of decades.

But clearly something has changed in the neutral rate since the Great Recession.  The fall in the neutral rate is no longer considered a “temporary” phenomenon by many.  Most people in the markets expect rates to be structurally lower for an extended period of time.  What happens when longer term (discount) rates are structurally lower?  Using new lower discount rates would cause equity discounted cash flow valuations go higher.  In our house example, even if the mortgage payment went down to $4,800 (lower earnings), if the discount rate goes to say 2% (from 6%), the house is worth $1.299 million.  So in our example, the house that looks too rich at $1.1 million is actually too cheap, even with lower cash flows (mortgage payments).  It’s possible it took people a few years to realize that the discount rate was “permanently” lower – just ask anyone who has been bearish tens this whole time.

To summarize,

  • I DO think the day or reckoning will eventually come for equities. We will get a population and investment decrease in the industrialized nations as the Baby Boobers roll over.  Take Japan as an extreme example.  When 120 million people are supposed to go to 80 million, I fail to see how that stock market won’t collapse (eventually) – especially when they can’t make a decent TV, cell phone or air bag any more.  But all the developed nations have a similar population issue to a lesser degree: (1) a lot of older people who have been savers/investors will need to cash out to become spenders and (2) developed countries have trouble growing the population (without immigration).  So if equities do go down significantly, I think we could REALLY go down.
  • I think the most likely timing will be much later (i.e. years)… long after everyone gets stopped out. Because relative to everything else right now, equities just don’t look that rich to me.  As one of my mentors, Clubber Lang, once said, “My Prediction? … Pain.”

Timing is very difficult – especially with equities.  However, I thought I would give you a different narrative than the “sell” narrative that the big boys have been saying lately.  I just keep hearing the same story over and over, and as a “relative value” guy, equities don’t look any more rich than say, fixed income, gold, bitcoin, London real estate or many other investments.  Call me myopic, but I don’t see the catalyst any time soon for the asset meltdown that people are talking about… for now.

[1] This is obviously not the same as an equity P/E – terminal value, uncertainty of cash flow, etc.  This example is just to illustrate a point regarding discounted cash flow.

[2] http://www.federalreserve.gov/newsevents/speech/yellen20151202a.htm