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.
