With positive profits and a zero discount rate, the price of equities is theoretically infinite. No one has produced quantitative models that show why this theoretical value never will be attained, e.g., the risk aversion of investors in an environment where profits might drop, and the prospect of a change in the investment opportunity set (exogenous shock, endogenous change in technologies that bring new competitors into the market). The broad indices are still a third lower than their peak values, and the question is how long they need to go before investors give up the 1.25% TIPS yield to buy equities that should offer somewhat better protection than nominal coupon Treasuries against inflation.
The enormous volatility we have seen around 10,000 for the Dow suggests that the market is worth perhaps 8,000 in a double-dip recession and 12,000 in a V-shaped recovery. In a prolonged Japanese-style stagnation, which has always seemed to me the most likely scenario, it probably is worth about where it trades at the moment.
Why shouldn’t stock prices simply regain past levels in the case of higher growth? As I wrote on March 8, stronger growth would imply a significant increase in interest rates, that is, on the discount rate on equities. I concluded:
The recovery of the S&P 500 since its March 2009 lows reflects an anemic level of earnings as well as a very low discount rate. A rise in the short-term interest rate (in reality, in the whole yield curve) could take a very big bite out of equity prices. I don’t quite believe that a 2% risk free rate implies a drop in the S&P by half — this is a numerical example rather than a realistic model — but it does highlight the sensitivity to watch out for.
Another way to measure the sensitivity is to compare the level of the S&P 500 under different expected growth scenarios at different risk-free rates. This we do in the chart below (click to enlarge):
To trade at present levels after an increase in the risk free rate from 0.25% to 2%, expected growth would have to rise from the so-called “new normal” of 2% real (or 3.5% nominal) to 5.5% nominal. In other words, a breakout into a new growth range along with a rise in interest rates would leave equity prices unchanged.
This extreme sensitivity to the discount rate on future cash flows puts something of a cap on equity prices: if growth really broke out to new levels the Fed would have to raise rates sharply. In that best-case scenario, the growth and the interest rate impact would cancel each other out.
That is the least of the market’s worries at the moment. The fear is downside risk due to a set of factors:
1) The European crisis, transmitted through the impact of defaults on bank capital ratios, and/or the impact of fiscal austerity;
2) A retrenchment by US consumers due to poor employment prospects and continued deterioration in the housing market. I have reiterated the case for disappointment in the labor market all year: in a creative destruction economy like that of the US, old firms shed jobs permanently and startups create new jobs. There is not a flicker of life in the startup world–no venture capital, no private equity, no sign of activity small business, zilch, bupkes, nada.
Regarding the housing sector, my old friend Laurie Goodman, now at Amherst Securities, argues that the apparent improvement in home prices during the past few months is a purely artificial quirk due to stretchouts of delinquent mortgages under the federal programs. These have delayed actual foreclosures and distressed sales by such a large extent that the proportion of distressed sales has fallen sharply in the total of new home sales, making it seem as if the average home price sale is higher. Her study is quoted in the Financial Times’ Alphaville blog.
The notion of a housing recovery seems fanciful when America has only 25 million households with two parents and two or more children, but 72 million housing units with three or more bedrooms. The baby boomers bought far more house than they required and hope to sell it at a profit; now they will retire to smaller quarters and the overhang of large-lot single family homes may take decades to work off.
3) Fiscal drag in the United States. I have called attention to the now often-cited problem of state and local government deficits, and the shift in attention from economic stimulus to the federal deficit remains another issue.
4) The limits of the Asian locomotive. Yesterday’s jump in the market apparently was a response to news of better than expected Chinese exports. China is not likely to explode, but the notion that Asian growth will rescue the world always was a bit strange.
None of the data we have seen thus far reflect the likely negative wealth effect from the stock market’s retrenchment. The poor jobs data are likely to continue, and consumer performance will be below expectations. Theoretically stocks can linger where they are, but the likelihood is that disappointing economic news will be the dominant factor — provided, of course, that some strategic disaster does not take precedence.
In a double-dip recession profits will fall.