Are Market Valuations Plausible, Or Short Of Silly?

by: Paul V. Azzopardi

In a previous article back in April, as the market was approaching old highs -- around the 1,500 level on the S&P 500 -- I asked whether it can go to new highs. On balance I thought not, unless there was something of a miracle, such as an accelerating China, plus a recovery in Europe, plus QE3 in the U.S. Well, we got QE3 in the form of QEinfinity at a politically expedient time, but other than that, the global situation actually got worse.

"How Did Stocks Get So High?" asked Bloomberg Businessweek in its September 17 issue. How did the S&P 500 manage to put on another $2 trillion this year when all around us, things get gloomier by the hour? Here are the main negatives:

  • the "fiscal cliff" in the U.S.
  • Europe, with an impending crisis in Spain
  • Eurozone growth forecast at -0.8%
  • Slower growth in China and India
  • Caterpillar (NYSE:CAT) and FedEx (NYSE:FDX) -- important barometers -- cutting earnings forecasts

But yet, here's a picture of how close we are again to the previous top before the crisis:

(click images to enlarge)

After I wrote the article in April, the market fell by 8% in June, but then it started up again and has now surpassed its April highs.

The BB article notes how hedge funds and individual investors are under-invested in equities and that, as stocks rise, these investors might be enticed back into the market. The important question, though, is "Why did hedge funds and individual investors stay out?" What kept them back was very probably the uncertainties surrounding a bleak economic scenario. And this perception is not only coming to light as Caterpillar, FedEx and other cycle-sensitive stocks revise their earnings downward, but also by Dow Theory.

Dow Theory Directions

Dow Theory states that the Dow Jones Transport Index (BATS:IYT), representing the main companies in the transport sector, needs be moving up along with the Dow Jones 30 for a bull market move to be confirmed. (It gets more complicated than this, but let's leave it at the 101 level.) And as we can see in the following chart, the Transports are not confirming the Dow:

Dow Jones 30 Index in Blue and the Dow Jones Transports in Red

We see that in mid-July, the Transports, which are indicative of future economic health, went their own way and were no longer moving along with the Dow.

So it seems that the market in general was dancing to a different tune from the economy; that while some investors were looking at the economy and stayed back, others were looking at something else and piling in. What was that "something else?"

That "something else" was money creation, in the U.S. and in Europe. Both central banks have decided to print as much money as necessary to get their economies out of trouble and, also, to keep interest rates low. Japan is printing too, and so is China, with $25 billion announced today.

What the Europeans and the Asians are doing is slightly different from what the Fed is doing, but it is wrong to argue that these operations are solely monetary and don't affect the real economy.

If a bank with faulty mortgage or other bonds can unload them at a good price on the Fed without having to write them off, reduce profit and replenish capital, and if, to make things sweeter, the Fed mandated that hardly any interest be paid on customer deposits, then this accumulating surplus of funds is likely to be invested in other assets. These assets may include Treasury and Municipal bonds, allowing government to continue borrowing at low rates and spend more. The monetary has, therefore, turned fiscal as government expenditure finds its way into the real economy.

Government Safety

Ideally, of course, the funds accruing to banks should go into new loans to small and medium-sized businesses, but the funds would only be lent out if the banks can clearly see a profitable repayment of the loan.

From firms' point of view, though, even if they have a good project, the interest rate they're charged is likely to be much higher than the near-zero percent we get on our deposits.

So the new funds accruing to banks follow the path of least resistance, and most of it goes into government securities because there's Uncle Sam's guarantee and this, in turn, goes to finance government spending.

Further, not only are banks' surplus funds going into Treasury securities but the Fed itself, which during 2009-2011, more than tripled its holdings of these securities, as the chart shows. This is considered a "no, no" in economic policy, as the Fed would be directly monetizing government debt, literally creating a trillion dollars, as in this case. Furthermore, all these purchases of government securities were accompanied by heavy buying by non-U.S. institutions, albeit recently, U.S. institutions are buying at a faster pace than the foreigners.

Graph of U.S. Treasury securities held by the Federal Reserve: All Maturities

So what we take from this is that this process is indeed, as the Fed states, positive for the economy and anti-deflationary, but since the money is either hoarded or flows mostly to government and public institutions, it is ultimately used inefficiently. In other words, government derives less output per dollar than the private sector; at some point, government grows too large and acts as a drag on economic growth; imbalance between public and private employment conditions continue to get worse, etc. One can argue, though, that spending on social programs, such as unemployment benefits, and otherwise giving money to people who need it and therefore, must spend it, is very potent in generating consumption and economic wealth.

If we continue down this path, will recovery take place? Yes. When? It's likely to take time.

The newly printed dollar, though, has another face. The first face, as we've seen, supports fiscal policy and slowly, though inefficiently, assists an economic recovery. The second face, which we'll consider now, has an immediate and drastic effect.

Your Friend The ZIRP

Let's consider what the ZIRP (Zero Interest Rate Policy) financed by QEinfinity implies:

  • First, borrowers can spend more than they otherwise could because interest rates are low. We have seen how this is true of government, but generally, not the private sector.
  • Second, borrowers have greater capacity for debt. However, we have seen that while governments are taking on more debt, companies are hoarding cash and paying off debt because, as yet, they cannot see enough profitable projects. Importantly, technology is making it possible for new projects to employ less people. Without new employment, human resources remain idle, skills are lost, and consumer spending is constrained, reducing feasible projects even further. Major world banks are still highly indebted and much of what we see is an effort to bring them to health ("derivatives time-bomb" permitting).
  • Third, billions of dollars are being lost in deposit and other interest, which ought to be paid to savers. Therefore, wealth is being re-distributed unfairly and the message being sent by the Fed and other central bankers is that saving -- and thus capital formation -- is a mug's game. Creditors are being punished and debtors rewarded -- this will be exacerbated when the real economy starts recovering and pushes inflation higher.
  • Fourth, the dollar devalues, thus increasing the competitiveness of labor (even as less labor is required) and rents, but increasing the cost of commodities as these are revalued. Bonds and deposits denominated in dollars fall in value, again re-distributing wealth unfairly. This may be the reason for the relative slowdown of Treasury securities take-up by foreigners.
  • Fifth, the discount rate is forced down and the value of assets -- immediately, and irrespective of the velocity of money and other considerations -- shoots up.

The fifth point is at the heart of what's most troubling with the present situation, and so merits more detailed consideration.

Up It Goes

An asset is worth zero if investors don't see any benefit to owning it. Put another way, an asset is only worth something if there are benefits associated with owning or possessing it.

Often, we cannot ascertain what those benefits will be because they are uncertain or even intangible. But if we can get a rough idea -- let's say the asset is a house, or a bond, or a dividend paying stock -- then we can take those future benefits and find an equivalent value today. The higher general interest rates are, and the more uncertain the benefits, the less this present worth would be compared to what we estimate we're going to get in the future, that is, the greater the discounted value.

In the old days, economists and central bankers used to be very critical of interest rates being dictated by the authorities, divorced from market forces, as was common in many socialist and communist countries. Now these peremptory near-zero interest rates have become the "new normal." Everyone seems to have forgotten that an economic surplus is created when money (or any other good) changes hands at the equilibrium market rate! Part of this surplus is being sacrificed to benefit one party instead of the other, in the same way as economic surplus is sacrificed when quotas, price controls, and excise duties are imposed on goods and services.

Any asset's present value of future benefits, as soon as news like QEinfinity comes along, is revalued upwards, and asset prices go up. People holding the asset will shift the price up for each quantity to be supplied, and those people wanting to acquire the asset will, likewise, shift the price up for each quantity demanded.

As long as the benefits associated with the asset are perceived to remain constant, the price of the asset goes up immediately, interest rates are lowered and/or more money is printed. This is asset price inflation.

We saw assets inflating when interest rates were kept low for too long by Greenspan's Fed post 9/11, and we are seeing assets inflating again now, preparing the way for the next crisis (unless there's a change in policy).

This is really what the charts of the Dow and the Transports are showing -- assets going one way, and the economy another.

Gasoline Highs

Asset revaluation is sometimes tempered by the realization that this price increase in itself will make the real economy worse off, but for the same size and pace of recovery, the price goes up there and then, on announcing the latest QE or other monetary initiative. Money does not need to move around -- there is no velocity component in this case. Gasoline goes up in price before it even hits the pumps.

But at some point, the people valuing the assets realize, as they did in 2007 and 2008, that the benefits associated with the asset are "not constant," and that the benefits do not justify the higher inflated price of the asset. Interest rates may indeed remain low, but the uncertainty surrounding those assets increases and the forecast benefits fall. So asset values come tumbling down.

Where We Stand

I think that the Fed's actions are likely to keep fueling a recovery, albeit a slow one. The recovery will speed up once housing gets healthier -- it seems to be well along in forming a base.

If the recovery is co-incident with the next election year or year three, then it's unlikely that the Fed moves to stem inflation, and inflation can then get rather nasty.

The process of deleveraging will move from banks and companies to nations, and the motive to control inflation would be even slimmer.

The competitive devaluation of currencies, including the U.S. dollar and the euro, is likely to continue.

Assets will continue to revalue, and we may be in for a series of minor (hopefully not major) crashes as asset price inflation gets ahead of economic reality.

As income investors, we have to do three things: (1) assess the stability and likely growth of income from an asset, be it a bond, preferred share, dividend stock, etc., (2) watch management and other agents to see if they are going to let us have what is due to us or whether they are going to appropriate it for themselves or someone else, and (3) watch the market to see when it will provide us the opportunity to get good value.

In the meantime, read or re-read Ben Graham's Chapter 8 in The Intelligent Investor, where he wrote about Mr. Market:

Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

This is not intended to be relied on as specific investment advice, nor as a solicitation to invest or trade any securities mentioned. We recommend readers to seek advice from an investment, tax, legal or other professional adviser. The information herein is based on sources we consider reliable, but we are not liable for their accuracy. Opinions expressed here may change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.