Tuesday, October 6, 2015

Is Today's Price to Earnings Relationship Indicating a Correction?

There are essentially only two factors that affect the price of everything. They are aggregate demand and the cash flow anticipated from an asset. Evaluating these two metrics with respect to stock and bond funds helps to determine fair market value, and whether the current price is reasonable or frothy.


The basis of aggregate demand is the number of people with the need for particular goods or services. If I am trying to sell one hundred watermelons from the back of my pickup truck on the side of a country road where only fifty cars traverse per day, it is highly unlikely that I will sell them all. However, if 1000 people travel that road per day, there is likely to be much greater demand to support my sales efforts. The population and nature of the population are objective determinants of aggregate demand. A forty-two year old with two children, on average, spends considerably more than a seventy-five year old. It is more likely that the forty-two year old is spending on home improvements, food and clothing for his growing family, automobiles, education, etc. than his seventy-five year old counterpart. Thus the aggregate demand for goods and services directly tracks age waves.


Because of the sheer size of baby boomers, following their age migration is a leading economic indicator. In the 1980s and 1990s, these baby boomers, who are the largest percentage of the population, were arriving at their peak spending years, thereby rocketing aggregate demand. Fast forwarding twenty to thirty years later to the present, these same baby boomers are either in or entering retirement. They have transitioned from maximum spenders to maximum savers. They have shifted from being the largest demographic paying into governmental programs such as Social Security and Medicare to being beneficiaries of such assistance. They have and will continue this transformation from being givers to receivers. It will be several years before the millennial generation reaches its peak spending years. And, because millennials have larger educational debt than baby boomers incurred and have fewer opportunities for lucrative income, they are delaying their own household formations, and hence are likely pushing out further the time period during which their spending will peak. All of this is easy to track. It is objective. And what we know is that demographics affect aggregate demand, and corporate earnings and GDP will be constrained by demographic headwinds and the associated limitations with respect to aggregate demand.


Now let's examine the market from the perspective of the cash flow and earnings generated by companies that comprise the major stock indices. The fact that companies' earnings have benefitted from low interest rates is undeniable. This fact in and of itself has inflated the price investors have been willing to bid for revenue and earnings. This is fairly obvious and often cited. What is less understood and appreciated is the impact of low and steady inflation with respect to rising prices investors have been willing to pay for earnings.


The Federal Reserve has not raised interest rates in over nine years. Since 2008, it has bought assets from the banks, and in the process has more than doubled its own balance sheet in the process. It has done this through working in a symbiotic relationship with the Treasury, whereby the Treasury has printed massive amounts of dollars, doubling the federal debt load within the last seven years. The objective of purchasing bank assets was to create demand for these assets beyond that set by the market, thereby suppressing interest rates in hopes of creating inflation. Interest rates have been reduced to levels never seen before. Today the federal funds rate stands at 0%. The most basic and fundamental economic theory says that lowering interest rates and flooding the economy with cash should be inflationary. There are very few relationships with such a strong cause and effect. Nonetheless, even after seven years of such "stimulus" and on a scale of absolute historical magnitude, we still are not seeing any real signs of inflation.


The Fed has orchestrated almost the perfect goldilocks scenario for price inflation based on maneuvering interest rates to the extent that they have made inflation appear as low and steady rather than high or deflationary. And while everyone cites low interest rates with market price escalation due to the paltry interest that can be earned elsewhere, the real impetus has been the ways in which they have camouflaged deflation through their massive cash injections. It is so important to appreciate that stock prices fall during periods of inflation as well as deflation. By creating this goldilocks scenario where the economy appears neither too hot to cause inflation but not too cold for deflation, everything appears "just right", and this produces the perfect backdrop for stock price inflation with respect to cash flow and earnings generated.


To better understand the price to earnings relationship and how this relationship is impacted by inflation expectations, I will use commercial real estate to provide context. A commercial property (if leased) generates cash flow. If the cash flow exceeds fixed expenses such as maintenance, taxes, and finance expenses, that excess is deemed "free cash flow". In a period of low and stable inflation, typically a buyer is willing to pay a higher multiple for that free cash flow. The price of the property is determined through assessing the free cash flow (yield) that the property should generate in comparison to what another investment would yield. In a low and steady inflationary period where interest rates are low and not moving significantly, the buyer of the property would compare the yield from the property in comparison with say what a U.S. government bond would yield or what a stock would yield. In a period where the yield from the government bond or the stock is low especially in comparison with the yield from the rental income, the property buyer would jack up his price bid to purchase the property and the cash flow that the property would likely generate. In periods where inflation is anticipated to rise, a similar buyer of the property would conclude that cash flow from the rental income wouldn't go as far, and accordingly would lower his price bid. Similarly, in periods of deflation, a prospective purchaser would conclude that he might have to lower rental income to remain competitive and fully leased. Consequently, in a deflationary period, the purchaser would lower his price bid.


I absolutely credit the monumentally experimental policies of the Federal Reserve with averting what could have spiraled in 2008 into a second great depression. And, it is also my contention that the prolonged and unorthodox policies of the Fed have been designed to prop asset prices, thereby resulting in people feeling "richer" and as a result spending more. I also believe that the fundamental weakness of the economy would be much more evident in the absence of their actions. After all, even with so much capital having been pumped into the system, we currently have one of the lowest percentages on record in terms of the working age population being gainfully employed. And, if everything is so wonderful, ask yourself, why can't they raise interest rates? And, why is such a small percentage of the working age population employed? And, why are we seeing record numbers of people on food stamps? And, why aren't wages increasing? And, why are commodities tumbling? And why is China slowing? And, why are we so worried about other countries slowing? And, why have we not seen top-line corporate earnings growth?


If deflation were obvious, prices would not have escalated as they have. If deflation is exposed once interest rates begin to rise, then prices will come down, and to the extent to which they were propped up, they might very well come tumbling down. The Fed has used extraordinary measures to cure an ailing economy. They want us to believe that they are in control and that everything is strong so that we don't lose confidence, suppress spending, and unravel all their efforts. Quite frankly, they are scared. Otherwise, they would not have resorted to such drastic measures. Try as they might to lower interest rates to stimulate growth, they are impotent to overcome demographic shifts and normal business cycles. To think otherwise is a fool's errand.


Most retail investors are allocated in ways that are conducive strictly for upwardly trending markets. Knowing that markets trend upwards, sideways, and downwards with fairly even occurrences, institutions, endowments, and pensions invest very differently than where retail investors are exposed, and in ways that are conducive for any direction. Our approach is much more aligned with the institutions and endowments. We are about complementing relationships rather than replacing them. No one person controls all the good ideas. Plus, it never hurts just to get a second opinion. If you would like specifics from our research or specific investment opportunities appropriate for sideways or downward trending markets, please email back. Also, you have my permission to forward this to anyone else whom you think would also would benefit.


Because retirement savings are too precious to waste,

Greg Gann




The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. There is no assurance any of the trends mentioned will continue in the future.

Thursday, February 12, 2015

Half Empty or Half Full: You Decide


Disclaimer: This is NOT about politics. This is not to be construed as a pro or a con for the Democrats or Republicans. This is strictly about economic reality. It is not about blame. Nor is it about proposing solutions.


Facts can so easily be construed to fit an intended audience that we often walk away questioning whether what we have just been told is lies, damn lies, or statistics.


Listening to the President's most recent state of the union address, made me feel that he and his administration should be treated as heroes. He reported that over his six year reign the stock market has soared, home prices have greatly recovered, the economy's gross domestic production has increased, industrial production is up, and above all else, the total number of jobs lost during the recession has been restored. I questioned how anybody hearing those statistics could possibly dismiss his accomplishments. I wondered why he is not getting the economic kudos that Clinton did. I pondered how anyone in his right mind could criticize this president. After all, this record is quite impressive.


Our President was conveying to us that economically everything is good, actually better than good, and that we have crossed the mountain, and that our troubles are behind us. Working with clients who are small business owners, professionals, and retirees, I had a hard time coming to grips with his message. There was such a disconnect.


My clients in each of these demographics are stressed. They are concerned about business growth and retention. They feel like the economy is resting upon a very precarious footing and that another correction could easily pop at any time, putting at risk their life savings. They also feel that the economy has been goosed and the market is rigged to make us feel better so that we spend more in order to lift the economy. They feel like a pawn in a chess game. And, furthermore, they feel that we could much more readily fall into recession, particularly if the punch bowl of monetary stimulus is removed, than we are likely to see another boom period like the 1980s.


So, who's right? And, is the economy half full or half empty? Are the statistics being mined to paint a picture that's prettier than reality? To help you answer these important questions, I would like to present some additional facts.


While what the President outlined was one-hundred percent true, there was some other objective data that was not revealed that might put things in better context. Again, this is intended strictly as a fact check and deeper overview. This is not an indictment on the President or the Democratic Party. Nonetheless, let's address those areas of the economy for which he takes credit.


President Obama took office literally at the depths of the financial meltdown and at a time where the stock market had lost 50% of its value. It is certainly a fact that the stock market is significantly higher today than when he was sworn into office. It is also true that monetary policies of historical significance have been enacted to depress interest rates to a point where money is virtually free. The government creates money by issuing debt. The federal debt since President Obama has been in office has increased roughly 70%. Most of the debt that has been issued has been absorbed by the Fed. How convenient. The issuer and the buyer are related entities.


Through the process of buying massive amounts of federal debt, The Fed has created a market and demand for those securities which would not otherwise exist in the market. This results in low interest rates. Low interest rates flood the market with cash. And, cash needs to find a home. More cash chasing the same number of shares of stocks results in stock prices surging. Low interest rates have also led to the stock surge because for very little amounts of money companies have been able to buy back massive amounts of their own stock, resulting in even fewer shares in circulation. When a greater supply of dollars chases fewer numbers of shares, guess what- share prices escalate. The Federal Reserve headed by Ben Bernanke and now Janet Yellen are most responsible for the rise in the stock market, not the President.


Any time you manipulate a market, inevitably there are unintended consequences. I believe that easy money helped get us out of the financial crisis. But, I also believe that it has been harnessed to an extreme and has not developed a solid foundation that will lead to on-going productivity. A house without a solid foundation eventually falls. And when the economy begins to tailspin after the zero fed funds rate policy is withdrawn, I wonder if President Obama will also take credit for the destruction since he certainly takes credit for the creation.


There are many other objective signs of weakness which might impact your view with respect to just how full is the glass. For one thing, the percent of the civilian work force age 25-54 currently employed is still significantly lower than January 2009. The number of Americans on Food Stamps is at a near all-time high, and significantly above the number on President Obama's original inauguration day. President Obama correctly stated that since he has been president, roughly two million jobs have been filled. What was omitted was the fact that the population has grown by approximately sixteen million over the same number of years.


Small businesses have always been the backbone of the American economy and the fulfillment and embodiment of the American dream. The Gallup Group reported that in the last six years, there have been more businesses going out of business than those being formed. In fact, there has been a net loss of some 70,000 businesses that have been laid to rest.


As reported in the September 27, 2014 issue of The Economist, which cited the Census Bureau and Sentier Research, under the Obama administration, GDP is up 8% and median household income is down 4%. In contrast, during Reagan's first six years in office GDP grew 22% and median income grew 6%. Clinton's first six years were even more impressive with GDP growth of 24% and median income rising 11%.


I don't quite understand how the standards for collecting Social Security disability benefits have apparently relaxed so much over the last six years, but a high and unsettling number of Americans are now not only working, but they are depleting funds from Social Security due to disability benefits.


Facts just now being released about the details of the final quarter of 2014 create a lot to mull over. Two for me were most impactful. The first is the huge and disproportionate percentage of personal spending that went to healthcare, which is not exactly productive or able to create a multiplying effect. The second is the Apple effect. Apple stock did so fantastically well in the fourth quarter due to its launch of the I Phone 6, and it is such a large component of the S&P 500 that fourth quarter earnings for the entire S&P 500 index would have been zero if Apple's earnings had been excluded. In other words, all the earnings growth for the entire index was attributable to just one single company, and its blow-put launch.


Is the economy half full or half empty? Everyone is entitled to his or her own opinion, and is free to use or excuse whatever data points he or she wishes. Regardless of one's choice data points, there are a few indisputable truths. They are that most of Europe is either flat lining or in recession. China is slowing. Argentina, Brazil, and Russia are on the ropes. Geopolitical risks in the Middle East could almost not be greater. Interest rates around the world are plunging to a point where are a large number of countries are literally charging for the privilege of lending to them, which is an indication of fear and a flight to safety. Greece might be forced to make a "Grexit" by being forced to leave the Eurozone. And, what happens to Greece has direct relevance for their cousins in France, Spain, and Italy. Yet, as ominous as all these truths are, the proverbial can just might continue to get kicked and kicked and kicked further down the road. And the market might just ignore the risks for a while. And, investors might scuff off anyone who speaks the truth as unknowing or negative or viewing the glass as half empty, and dismiss all the warnings that are flashing in big neon lights. They always do. And, then they say, "everyone with half a brain could see it coming". Except, they were part of the "everyone" who wasn't protected.


No one can predict the future with certainty. I have no idea where the market will close tomorrow or the next day or the day after that. However, I am confident that if interest rates don't elevate over the next 5-7 years, we will be in the midst of a deep global recession of significant magnitude.


Since the process of lowering rates has jacked up stocks and bonds, what has been a tremendous tailwind for these two assets will become a headwind once rates rise. So, over the next 5-7 years, we will either have higher interest rates or we will be in the depths of another 2008 type recession. In either scenario, stocks and bonds are not the assets on which you would want much of your retirement to rely. Investments whose performance depends on the underlying market moving north should carry a huge warning sign. The can might be kicked and kicked and kicked down the road, but at some point every road ends. These are not normal times. Therefore, they require alternative strategies and investments typically associated with institutions, pensions, and endowments, but where retail investors are seldom exposed. Betting aggressively over the last six years that the glass is half full has prevailed, and big time. I am not willing to bet that it is half empty, but I am clearly not willing to bet my future or our clients' futures that it is half full and that it will remain that way over the next critical 5-7 years.


No one person has a monopoly on all the good ideas. Plus, it never hurts to get a second opinion. If you would like sound "out of the box" investment ideas or a second opinion from a seasoned financial advisor who has survived numerous booms and busts, consider this my invitation for a personal consult either in person or phone.


All the best,

Greg Gann


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The opinions expressed in this material do not necessarily reflect the views of LPL Financial. There is no assurance the trends mentioned will continue or that the forecasts discussed will be realized. Past performance may not be indicative of future results.

Securities offered through LPL Financial, Member FINRA/SIPC.


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