I’ve been fairly adamant that I am not a big fan of government policy that is specifically designed around the stock market and keeping prices “higher than they otherwise would be”. Maybe it’s just the old risk manager in me, but I think those of us with a lot of experience trading stocks and other sensitive assets understand how fragile these markets can be. I also think it can be hard for non-market practitioners to fully understand why QE bothers market practitioners.
Anyhow, I really like this quote from Howard Marks about how to think of secondary markets relative to their underlying corporations (via PM Jar):
To me, the answer is simple: the better returns have been, the less likely they are – all other things being equal – to be good in the future. Generally speaking, I view an asset as having a certain quantum of return potential over its lifetime. The foundation for its return comes from its ability to produce cash flow. To that base number we should add further return potential if the asset is undervalued and thus can be expected to appreciate to fair value, and we should reduce our view of its return potential if it is overvalued and thus can be expected to decline to fair value.
So – again all other things being equal – when the yearly return on an asset exceeds the rate at which it produces cash flow (or at which the cash flow grows), the excess of the appreciation over that associated with its cash flow should be viewed as either reducing the amount of its undervaluation (and thus reducing the expectable appreciation) or increasing its overvaluation (and thus increasing the price decline which is likely). The simplest example is a 5% bond. Let’s say a 5% bond at a given price below par has a 7% expected return (or yield to maturity) over its remaining life. If the bond returns 15% in the next twelve months, the expected return over its then-remaining life will be less than 7%. An above-trend year has borrowed from the remaining potential. The math is simplest with bonds (as always), but the principle is the same if you own stocks, companies or income-producing real estate.
In other words, appreciation at a rate in excess of the cash flow growth accelerates into the present some appreciation that otherwise might have happened in the future.
Marks is referring to the fact that markets have a tendency to get out of whack because participants often price in cash flow growth that doesn’t end up materializing or doesn’t end up justifying prices. The Nasdaq bubble was basically one big case of this happening. Market participants thought the future cash flows of all internet related companies would soar through the roof. So they bid up prices to reflect the fact that these future cash flows would soon justify the current prices and then some. The problem is, things got way out of hand and market participants started to price in cash flows that most of the companies could never produce. It was a classic bubble environment. I think this happens in a more near-term phenomenon in what I’ve called “price compression”.
Warren Buffett has also discussed this phenomenon:
Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.”
The worry with a program like QE is that it entices irrational market participants to become even more irrational. In other words, keeping asset prices “higher than they otherwise would be” could lead to prices that don’t come close to resembling the underlying cash flows. Of course, I don’t know if that’s occurring in the market at present, but I do think that programs like QE, which are widely and terribly misunderstood, increase the odds of market disequilibrium. And that’s a systemic risk that I think is unnecessary at present given our other policy options.