Upside-Down Markets: Profits, Inflation and Equity Valuation in Fiscal Policy Regimes

davfor

Massive fiscal and monetary stimulus. TINA and rising P/E ratios. What to think and how to respond? The closing sections of this long and winding article provide a plausible idea concerning the stock market's future direction.

TINA markets are guaranteed to be difficult and frustrating for large numbers of people. The problem of how to properly invest in them has no easy solution. Chasing ultra-expensive assets, nervously supervising them in the hopes that you haven't top-ticked them, is stressful and unpleasant. But so is waiting on the sidelines earning negative real returns while everyone else makes money. Time is not on your side in that effort.

Over time, as the COVID-19 deficits collect in the hands of savers, they will end up functioning as direct injections of cash and treasury bonds into investor portfolios. These injections, which will represent insertions of new wealth rather than alterations in the composition of existing wealth, will raise allocations to cash and treasury bonds and reduce allocations to every other asset class—most notably, equities.

Do investors actually want to have their allocations to equities reduced in this way, replaced on a percentage basis with cash and bonds? Probably not, especially with the Fed having just lowered interest rates to zero. But they don't have much choice in the matter; if they don't want to accept the reduced allocations, then their only available option, outside of investing in new companies or in companies that are diluting, will be to push up on the prices and valuations of existing shares.

....on the assumption that investors display zero sensitivity to valuation and invest entirely based on a pre-determined asset allocation preference, we can quantify the exact impact that the COVID-19 deficits would be expected to have on prices, if they found their way into markets. We simply assume that investors would bid up on the price of equity until their pre-pandemic allocation to equity was restored. To restore that allocation amid the COVID-19 debt issuance, the market would have to rise by roughly 18%, from its price at the time of the writing of this piece, roughly 3327, to a final price of roughly 3900, a forward 2-yr GAAP price-earnings ratio of 26 times.

In exploring the supply-driven effects that fiscal policy can have on asset prices and valuations, we've once again arrived at a classic upside-down outcome. An event occurs that damages the economy, forcing extreme issuance of zero-yield government debt, the presence of which pushes down on average equity allocations and up on equity prices and valuations, contrary to the assumed effect of the damage itself.

https://osam.com/Commentary/upside-down-markets

WABAC

Strange pick for the writer to call himself Jessie Livermore.

In thinking about the limits of fiscal policy, we should not be lulled into complacency by the U.S. economy's recent lack of inflation. There is a limit, a point at which fiscal expansion would trigger an inflation that would only be controllable through the use of unacceptable interventions. We may not know where that limit is—whether it will come in to play at a Debt-to-GDP ratio of 150%, 200%, 250%, 500%, 1,000%, 2,000%, 100,000%, and so on. But we can be sure that it exists somewhere, right now, as we embark on an effort to explore it.

Gonna need more than a picnic basket on that journey.

Valuation acts in opposition to this process. If investors are sensitive to valuation, rising prices will reduce their desire to allocate to equities. But it's difficult for valuation to gain traction as a consideration in the current environment. The relevant value proposition that investors have to consider is an awkward proposition that pits positive-but-historically-depressed earnings yields in equities against zero yields in everything else. Rising equity valuations cannot easily shift the balance of that proposition for at least two reasons. First, equities can produce attractive returns even when purchased at elevated valuations, provided that they stay at those valuations—and in the current case, they very well might. Second, the alternative proposition—earning a negative real return for an indefinite period of time while others continue to make money--is simply unacceptable to many investors.

We refer to this logic as the logic of TINA—"There is No Alternative." The logic is sound, but it has limitations. Equities aren't going to rise to infinity—an earnings yield of zero--simply because the competition is yielding zero. As equities become more expensive, they become more "needy", more sensitive to declines in buyer enthusiasm. Their neediness and dependence on continued buyer enthusiasm increases their potential for inflicting losses.

I'm not sure this adds up to anything more than buying the dip. But I skipped over the jaw-breakers in the middle of the article.

davfor

The link between current household asset allocation and stock market performance the last section of the article highlights is interesting (this has been a long term emphasis of the author --
http://www.philosophicaleconomics.com/2013/12/the-single-greatest-predictor-of-future-stock-market-returns/ ). My takeaway is this link may provide a simple framework for projecting the overall trend for the stock market as our economy works its way through a period of negative growth in an intermediate term environment anticipated to be characterized by substantial fiscal policy stimulus and near zero percent interest rates. The article indicates this environment will over time lead to an upwardly trending market if in aggregate households do not reduce the percent of assets they allocate to stocks. And, it suggests that something approaching this simple overall "no change" decision will likely be made by households in aggregate assuming a return to sustainable intermediate term growth continues to appear probable.

WABAC

davfor said:

The article indicates this environment will over time lead to an upwardly trending market if in aggregate households do not reduce the percent of assets they allocate to stocks. And, it suggests that something approaching this simple overall "no change" decision will likely be made by households in aggregate assuming a return to sustainable intermediate term growth continues to appear probable.

So what about people selling stocks to finance their retirements? I honestly don't know. Maybe we're such a small percentage of the market that it doesn't make any difference.

Twenty-six time PE (or whatever) may be the new normal in this environment. But it seems like a sneeze can turn into a pandemic anytime it goes much higher.

davfor

According to the most recent Federal Reserve data, the top 1 percent of U.S. households by wealth own 39 percent of equities and mutual fund shares, and the top 10 percent own 83 percent . Also, the top 1 percent of U.S. households by income own 41 percent of equities and mutual fund shares, and the top 20 percent own 87 percent.

https://federalreserve.gov/releases/z1/dataviz/dfa/distribute/chart/#quarter:122;series:Corporate%20equities%20and%20mutual%20fund%20shares;demographic:networth;population:1,3,5,7;units:shares;range:1989.3,2020.1

This data suggests the need to sell shares to fund retirement needs is likely to have a fairly small impact on stock market behavior. (I just noticed @Mark posted some of this data on another post earlier this morning.)

The quote already pasted to this thread about valuation and TINA speaks to the PE ratio question. That's a daily marketplace decision. But, that decision takes into account the knowledge that central banks are active participants and that fiscal policy is also playing an active role in supporting the economy. The quote suggests it will be difficult for valuation concerns to gain traction in this environment. I suspect if the upward creep in the P/E ratio is gradual the marketplace will continue to accept it assuming the economy can return to a pattern of growth (but I am certainly not betting the farm that is the case). But, what happens if (when?) inflation takes hold? That will presumably force central banks to modify their behavior. The limits of MMT tie in with this too. But, it appears the marketplace views those issues as distant concerns for another day.

hank

the top 10 percent own 83 percent

Do you think any of that top 10% participate in mfo discussions? Let’s hope so. Otherwise, the good people who come here to talk about investing represent (at most) only 17% of the market. A dismal thought.

FD1000

Unfortunately I have to post it again

Over the years we heard the following:
1) US stocks are over value, the rest of the world is undervalue. US stocks did better in the last 10 years.
2) The GMO team and Arnott have been wrong for 10 years.
3) Gundlach was way wrong when he predicted the 10 year will be at 6% in 2021
4) Bogle was wrong when he predicted stocks/bonds performance based on the past and averages.
5) Inflation and interest rates can only go up. Both wrong for years.
6) inverted yield signals recession = wrong. High PE, PE10 signal the end of the bull market...wrong again for years.
7) There is no way stocks will have a V recovery in March 2020 based on blah, blah, whatever...and they did.
8) The economy is bad, unemployment is high, the debt is huge = bad future stock market. The reality? Stocks are still up.
9) If Trump will be elected, it will be a disaster. Reality? stocks were up
10) New predictions a) The new president will be XXXX so do something now b) Covid-19 cases will be up c) China-US relations got worse

The Fed successfully managed to do all the above and why many "experts" were wrong

If you didn't get the message already, most investors should do nothing to very little. Predictions are a flipping coin. Some will be correct just because markets go sometimes down.

Crash

see that other thread, too, where the discussion carries a bit different flavor.

WABAC

FD1000 said:

Unfortunately I have to post it again

No. It wasn't necessary at all. We heard you the first time.

Farmers talk about the weather. Investors talk about the market.

davfor

@FD1000 Your comment puzzles me. The section of Jessie Livermore's commentary that discusses equity market valuations is fairly bullish. It provides support to the TINA perspective and to a gradual rise in the P/E ratio in the current investing environment. (However, the author does appear to be certain a problem will arise if the P/E ratio eventually approaches infinity!) Your copy and paste list appears to be a carpet bombing attack focused on bearish perspectives. It's not clear how it relates to his comments.

By the way, its my sense you invest as a market technician. Old_Skeet frequently posted comments that provided technical insights relating to stock market conditions. Junkster occasionally offered his technical insights related to bond market conditions. Your posts related to bond fund investing have had a technician's perspective. Hopefully, there will be more of those posts to come.....

FD1000

davfor said:

@FD1000 Your comment puzzles me. The section of Jessie Livermore's commentary that discusses equity market valuations is fairly bullish. It provides support to the TINA perspective and to a gradual rise in the P/E ratio in the current investing environment. (However, the author does appear to be certain a problem will arise if the P/E ratio eventually approaches infinity!) Your copy and paste list appears to be a carpet bombing attack focused on bearish perspectives. It's not clear how it relates to his comments.

By the way, its my sense you invest as a market technician. Old_Skeet frequently posted comments that provided technical insights relating to stock market conditions. Junkster occasionally offered his technical insights related to bond market conditions. Your posts related to bond fund investing have had a technician's perspective. Hopefully, there will be more of those posts to come.....

In the last several years and especially in the last several months I have heard so many bearish stories and why I made my comment. Most investors shouldn't try to time the market and/or make big changes. My comment included several "experts" to show that even they can't predict the market.
Sure, stocks PE is high and bond yield is low but the long term concepts of investing for most investors should stay about the same.

I'm mostly a bond trader with very specific goals according to our needs: we need just 4% (including inflation) for decades to come to keep our current lifestyle, with that in mind I want to make 6+% average annually + never lose more than 3% from any last top. The trades involve technical aspect but others things such as VIX and my generic perception of current risk/reward. When I trade stocks/ETF/CEFs/GLD/other is usually hours to days and involve mostly technical analysis and/or when I see screaming buy opportunities (I had several in 03/2020)