With equity markets soaring, both investors and speculators must be expecting a V-shaped recovery, a resumption of earnings growth, and commensurate ongoing appreciation in stock prices. The path of least resistance is upward as the demand from speculating surfers is exceeding the supply from investors who, in the midst of perplexing mixed signals, are standing flat-footed on the shore as the wave of liquidity whipped up by the Fed obscures the ebbing of the economic tide.
The speed, magnitude, and breadth of the Fed’s response to the current recession and coinciding market meltdown that ended March 23 is without anything approaching historical precedent. On the right side of Figure 1 the expansion of the Fed’s balance sheet (red line) from $4.19T to $6.95T, as well the precipitous fall in Fed Funds rates from 2.45% to zero, is displayed. There were lags between stimulus and response following the preceding two recessions (shaded blue) and the bull markets that followed. There has been no such hesitation in 2020. In response to the profound and perplexing uncertainty of the economic fallout from the coronavirus pandemic, Fed Chairman Jerome Powell’s assurances were an open-ended, green-light commitment without equivocation to do “whatever it takes.”
Well-trained market speculators responded to the messaging from the Fed like Pavlov’s frenetic dogs. In little more than three months the S&P 500 retraced 75% of the ground lost since its February 19 peak. The NASDAQ composite, led by the resounding tech favorites, the FAANG stocks plus Microsoft (FAANMG), is trading at 9.5% above its February 19 now-eclipsed record.
The wave of enthusiasm for pick-of-the-litter technology stocks has touched new all-time highs, behind which the broader S&P 500 seems to be pulled upward by a valuation vacuum. The hard-asset light cohort of FAANMG is priced for comparative perfection, as the following table indicates. Winner-take-all information technology monopolies, a combination of first-mover advantages, and the network effect seem almost to be taunting Congress for regulatory oversight. The price-to-sales ratio and the EBIT margin (earnings before interest and taxes divided by revenues) for the S&P 500, including the FAANMG, is a minuscule 2.3 times and 3.75%, respectively. For the FAANMGs, the comparable numbers are a breathtaking 23.1% and 7.3%, respectively.
Bullishness Will Ride the Wave of Liquidity
Bullish investors ground their enthusiasm for stocks in different features of the Fed’s response, despite tenuous real links between Fed actions and equity markets.
Some argue that the liquidity the Fed has provided through its various programs, primarily to banks, will “find its way into the stock market.” Market analyst John Hussman reminds us, however, that such is literally impossible. When one party buys a share with cash, the seller receives that cash in equal amount. Cash changes hands, but the market cannot soak up money like a sponge that holds more or less at different times.
Only initial or secondary offerings of debt or equity actually absorb cash from investors. Companies know the difference. As markets have recovered, they are tapering a historic streak of share repurchases and flooding the markets with debt offerings and, to a lesser extent, even announcing secondary equity offerings. While the postmortem on the buyback binge won’t reflect well on many CEOs, when C-suite executives are suddenly staring down the muzzle of a recession/depression shotgun, their behavior is vintage 1930s.
Facing an economic crisis suddenly puts career risk in sharp relief. It has been a decade since executives have faced the very real test of actually running their business under conditions of macroeconomic duress. In unexpected emergence of this new normal, financial engineering is now passé, shifting the decision-making burden from the CFO to the CEO. Like the regularly out-of-sync bankers who invariably take the greatest risks precisely at the wrong times, many non-financial corporations, to the long-term detriment of committed shareholders, will default into a cash-preservation mode more than strictly necessary. As evidence of the breakdown in the agent/principal relationship, dividends and capital spending will be sacrificed in the name of the agent’s self-preservation. Principals, as well as principles, be damned.
Stocks Will Swell on Inflation
Others claim that the Fed is printing money, which will lead to inflation. To the extent that stocks are a claim on physical corporate assets, they should act as a hedge against rising prices. We see three problems, however, with this perspective. First, it ignores the fact that equities are trading far and above the book value of the shareholders’ claim on assets. Second, equities are priced with expectations of extravagantly high future cash flows. Even if we entered an inflationary environment, history doesn’t indicate that inflation would sustain record valuations. Earnings aren’t guaranteed to grow as costs may not be passed through and a rise in interest expense would be a drag on net profits. In periods of hyperinflation, the case in both the Weimer Republic and Venezuela, equity markets behaved differently, but that is not a scenario the U.S. faces.
Third, when the Fed engages in quantitative easing (QE), it is substituting one asset (cash) for another (Treasuries). This creation of money is not increasing demand. That is a function of bank lending, which (since Bernanke’s response to the Financial Crisis) has remained stubbornly low despite the massive infusions of QE.
While the Fed’s extraordinary actions regarding corporate bonds might be different and are unquestionably more complex, such actions have so far been fairly reserved relative to expectations. Thus, beyond psychological factors we see no reason for QE to inherently propel equity prices higher. In fact, the very point demonstrated by Pavlov was that habituation is the result. Dogs salivated for their reward irrespective of whether it was proffered. The problem for a continuation of high equity valuations is that psychology is fickle. It can change faster than investors can take cover.
Low Interest Rates Demand High Valuations
Perhaps the most intrinsically illogical argument for high valuations is low interest rates. As fixed-income assets generate infinitesimal yields (U.S. 10-year bond, <0.6%), desperate investors, in order to put figurative bread on the table, are hard-pressed to scramble for higher returns. Arbitrage ensures that equities will be bid higher as their dividend payments (S&P 500, 1.76%) are more valuable than the lower-return, fixed-income alternative. That doesn’t mean equities offer a reasonable or satisfying return, though. Hussman paraphrases this logic: “Future stock returns are likely to be dismal, but dismal returns on stocks are justified because you’re going to get dismal returns on bonds too.”
Historical correlation demonstrates the likelihood of poor returns. The higher multiple one pays today for any given set of future cash flows, the lower a return the investor should expect in the future. Here’s a scenario to illustrate the point. Suppose in 2019 you were to buy a one-bedroom apartment as a rental in San Francisco. You knew the landlord next door was charging $4,500 a month and had profits of $37,000 after property taxes for the unit he owned. His and your prospective property were the same quality and style. What would you have paid for the available property? Giving the robust market in San Francisco the benefit of the doubt, let’s say you determined a 5% annual return was sufficient and thus valued the property at $740,000. Unfortunately, the market price for this home was $1.25 million, for a return of 2.96%. Still, that was better than the yield on a BBB-rated bond. You decided to take it. By the logic of today’s equity investors, with low interest rates, you should reasonably expect lower returns.
Then the coronavirus comes. Tech workers exit San Francisco to work remotely in cheaper and smaller cities and towns. Prices plunge. As you list the apartment, you take a 20% haircut on the asking rate. Now your return is 2.1%. You get a tenant. Then your neighboring landlord sells his apartment for an even $1.1 million. At the current 2.1% rental income return, it will take more than 10 years to earn back the loss from the market value of the property.
We use real estate to illustrate the point because transactions in tangible physical assets are generally more familiar. Many overlook the fact that intangible equity investments function similarly. A common stock is a claim on a business and its assets every bit as real as a deed is to a home or apartment. During a mild recession, investors could expect a cut to dividends (in our analogy, rental rates) and a retreat in share price (property price). Equity markets tend to be far more volatile than housing, though. Within the last 20 years there have been two major reversals in equity prices that have exceeded 60% in the S&P 500. Parenthetically, the Case-Shiller U.S. National Home Price Index decreased just 25% through the six years following its 2006 peak; it didn’t return to that level until 2016. Historically speaking, whenever stocks were valued as highly as they are today, 10 years hence returns were flat to negative.
The Mechanics of Dismal Returns
Perhaps this time is different, though. We’re on the verge of a flood of new and potentially productive technologies. Artificial intelligence, self-driving cars, 3-D printing, alternative energy, and countless other products and developments could provide corporations with new sources of robust cash flows. Though stock prices are high, it’s conceivable we can grow our way into current valuations. After all, the price paid is not the only determinant of future returns. It is, however, the most important, even for the current 10-year return.
We have written extensively on the chronic decline in growth among the major developed economies, stubbornly weak growth in productivity, and the difference between revolutionary and incremental technological change, all of which would find the above technological optimism suspect. But we have also had low interest rates and sub-2% inflation for over a decade, and that has its own not-so-subtle implications for weak growth.
When the cost of capital is extraordinarily low—debt is dirt cheap and equity prices command irrationally high valuation premiums—management can, and in fact is encouraged to, engage in projects with lower rates of return. A cost of capital of, say, 2% means any project yielding above that is profitable. The best illustration of this dynamic is the shale-oil industry. This revolution in oil production was catalyzed by low interest rates. With required rates of return so low—courtesy of interest-rate suppression resulting from QE—shale drillers had sudden access to cheap enough capital to make their projects viable. Consequentially, enormous amounts of capital have been invested in the shale sector. Returns to investors, however, have been poor to negative.
That story is repeated, though, across corporate America. When the threshold for the required rate of return is low, capital is misallocated. Investments are made in low-return projects. Subsequently, growth is proportionately anemic. This is the second reason why equity returns can be expected to be low. It is because interest rates are low. Malinvestment is permitted to run rampant, and no economy will experience dramatic growth without prudent investment that demands the returns necessary for that dramatic growth. Ultimately, stock performance is tethered to the performance of the economy itself.
Truth Cannot Be Denied
We are not merely in the midst of a global pandemic and recession. We are deeply into a crisis of low interest rates that have hobbled the major economies of the world with the growing scourge of fair-weather-only investments. This latent crisis has been decades in the making. The recent complications of the coronavirus, tragic as they are, are tearing the bandage off a gaping wound. Low interest rates and poor returns promise to produce only more of the same. While it would be antisocial to wholly correct the misguided path of monetary policy since Greenspan in a New York minute, the actions the Fed is taking—dropping interest rates to zero, prolonging malinvestment by propping up junk-bond prices, and doing all it can to paper over structural weaknesses in the economy—are exacerbating the problems rather than providing a sustainable cure. Medicines are poisons in large and prolonged doses. The economy has been on its current prescription far too long, and the dosage was just increased.
All financial history would indicate that prospective returns for U.S. equity markets are almost uniformly dismal 10 years hence. Further, it’s almost inconceivable that an index would trade sideways for such a period. Just as no sin goes unpunished, extreme overvaluation has virtually always had its comeuppance in bear markets that invariably see prices swoon below their long-term mean and deep into bargain territory.
Unfortunately, most investors are unable to take advantage of the fortunes that such an opportunity presents. Instead, they are surfing the present rogue wave even as the tide begins to ebb. They are unaware that, unlike largely imperceptible tidal currents, waves are not the actual movement of water but rather the visible results of moving energy. The fierce winds from the Fed’s recent policy changes have resulted in a wave of renewed confidence by speculators. The energy in their enthusiasm, as demonstrated above, is predicated on anticipated effects like liquidity and inflation that are likely to prove illusory.
Still, absent selling from those who see the wave as transitory, investors turned speculators are capable of pushing the crest of the current market even farther upward. The energy in waves, though, works in both vertical directions. The higher the crest, the deeper the trough. Once the drama of the wave is past and calmed seas settle into the lower levels of the ebb tide, it will be abundantly clear which investors and businesses are swimming sans swimsuits. For those who understand the difference between waves and ebb tides, the possibilities presented will be the opportunity of a lifetime. In the immortal words of Rudyard Kipling in the first stanza of his well-known poem If:
“If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too …”
The market is yours.
 Tobin’s Q captures the relation of market price to underlying asset-replacement value. While this metric is of less utility in the age of tech stocks (the leading of which represent about 20% of the S&P 500, FB, AMZN, AAPL, NFLX, MSFT, GOOGL) laden with intellectual property, which is underrepresented on the balance sheet, it remains the case that S&P 500 market caps in aggregate far exceed the capacity of the underlying assets by a factor twice the average—and 5–6x the ratio at secular market lows.
 Most instances of hyperinflation have not resulted merely from an increase in the monetary base, but from destruction of productive capacity during either war or the social redistribution of capital. This supply shock is an important component of the phenomenon. Further, from the U.S. market low in 1974 through the mid-1980s, inflation was double digits in the U.S., but markets, working from a low CAPE ratio, went almost nowhere for a decade. We cannot imagine that high inflation would do the opposite now when valuations are already at a historical peak.
 Corporate A-rated bonds are yielding 1.66% and BBB-rated bonds 2.49%.