We are in a long term worldwide workout situation with respect to our indebtedness. What some call the age of deleveraging and others call the age of austerity both accurately describe the current environment of (1) too much individual debt, (2) too much debt accompanied by ongoing government operating deficits and (3) either too much government spending or too few tax receipts, or both, relative to our total output.
Obviously our country has arrived at what we all know are unsustainable debt levels, as have many individuals, families, municipalities and states, too. This has now gone on way too long, and the cure, unfortunately, will take way too long as well. I wish it were otherwise, but that's the way I see things. See Inside the Disappointing Comeback.
With respect to the investment climate, however, we may well be at a very good entry point, assuming we have the stomach to handle a bit of a turbulent ride. The equity markets appear undervalued and excessively discounting the prospects for an even weaker economic environment than is likely. (Of course, my crystal ball is only my take on things, so please consider these views for what they may be worth, which may be nothing.)
In any event, reconciling these seemingly inconsistent points of view of a relatively weak U.S. economy and a reasonably strong market in which to invest is essential if we are to become comfortable with the idea of investing in a slow growth, high unemployment economy.
First, the economy.
Although we'll most likely avoid another recession, the economic situation will remain subpar for a lengthy period due to the ongoing payback effect of all the debt we've incurred during the past few decades. In large part we borrowed the money to add to personal spending instead of investing in productivity gains, so now we'll have to repay that which we borrowed without any benefit of added output therefrom. In large part we'll do that by reducing our personal spending. To put it simply, we consumed more than we produced for many years, and now we'll reverse that process and consume less than we produce for the next several years.
As we spend less, debt liquidation will take center stage. Keynes wrote about the "paradox of thrift" which simply argues that while individual savings and debt repayment are good from the point of view of the individual, when the practice becomes pervasive across the society, the paradox is that total savings throughout the society decrease. Economist Irving Fisher wrote about what he referred to as the "debt deflation" cycle of the Depression era, and Hyman Minsky later formulated what is named the Financial Instability Hypothesis (FIH). Please see an explanation of the Minsky view in the 2007 WSJ article In Time of Tumult, Obscure Economist Gains Currency). Minsky explains how speculative financial bubbles (such as the recent housing bubble) are triggered by excessive non-governmental debt accumulation, and end up causing widespread havoc when the bubble inevitably bursts. That pretty well sums up where we are today.
For those interested in more of a detailed discussion about sovereign debt bubbles, there's an excellent book titled "This Time Is Different: Eight Centuries of Financial Folly" by Reinhardt and Rogoff. As the tongue-in-cheek title indicates, government debt catastrophes are nothing new. Neither are their causes, and they take many years to correct.
Due to our excessive indebtedness, interest and related payments on that growing debt will probably cause our own economy to experience ~1% less real growth each year for the foreseeable future. Since we only grow in normal times at a roughly ~3% rate, reducing that economic output due to debt servicing requirements will result in economic growth at a 33% slower pace than normal in the coming years. That's a major reason why we will continue to experience relatively high unemployment, too. We'll deal more with with what Keynes, Fisher and Minsky had to say at a later time, but suffice it to say for now that the debt problem isn't going away anytime soon.
In any event, the short term economic impact of servicing and hopefully someday soon beginning to repay the debts will require saving in lieu of spending. As we necessarily spend less and save more, accompanying that sound long term decision will be a weaker economy for a period of time. Because we've dug a really deep hole for ourselves, it will take a long time for us to dig out of that hole. But dig we must, and when we've finished digging, we'll be the better for having done so.
Now let's move on to the better outlook for the world of investing. {I'm assuming that we'll do what's necessary to begin to address our financial issues in earnest. To paraphrase Samuel Johnson, the prospect of being hanged focuses the mind wonderfully.}
During the past thirty years, both stock and bond investors have had the tailwind of continuously declining interest rates. As a result, it's been a great time to own bonds (even though they still didn't keep pace with stocks). In 1981 thirty year treasury bonds yielded a seemingly astronomical ~15%. Ten years later in 1991, they earned a still extremely high ~9%. Today they yield less than 4.5%. So the bond investor enjoyed both high interest rates and an appreciating bond price for the last 30 years, because bond prices move up when interest rates go down.
Simply stated, that's the underlying reason for my conviction about not planning to own government bonds for the next decade or more. Having said that, if we experience general deflation resulting from the current debt deflation situation, of course, then I'll be wrong, at least for the short term. Looking out thirty years, however, I have a very high level of confidence that interest rates will be higher than they are now.
In any event, we're definitely in a genuinely slow growth mode for now, and upon resuming normal speed down the road, whenever that may be, we will then witness gradually rising interest rates. Hopefully, we'll avoid excessive inflation but for now, inflation worries are not an immediate or even an interim concern. As rates rise, bond prices will fall, and that loss in value will probably not be fully offset by the interest income paid on the bond.
In sum, the past thirty years witnessed both rising bond prices and high initial interest rates paid on those bonds, both of which worked to the advantage of the bond investor. The next thirty years will see a complete reversal of that high rate beginning and low rate ending scenario, thereby resulting in a poor investment climate for "safe government" bonds.
In comparing investment opportunities, we need to consider the relationship between interest rate levels and stock prices, since stocks and bonds are competing investment choices.
As an example, if the price of a stock is $90, its per share earnings are $6 and the then current 30 year treasury bond interest rate is 4.5% (some use the ten year bond rate and others use the corporate bond yield, but we'll use the 30 year treasury yield), we have enough facts to render a reasonable opinion regarding whether stocks are a good investment choice. Here's how we look at it in simple terms.
If the company's stock price is $90 and the company's earnings per share are $6, the P/E (price to earnings) ratio is 15, which is calculated as follows: 90 divided by 6 = 15. The reciprocal of the P/E ratio is known as the earnings yield: 6 divided by 90 = 6.67%.
When the earnings yield is less than the bond yield (in this example 4.5%), stocks are usually overvalued. When the earnings yield is greater than the interest rate on bonds, stocks are usually undervalued. Since the earnings yield on the stock is now 6.67% and the bond yield is 4.5%, we get substantially more current "earnings" by owning stocks.
Of course, we aren't actually paid any money as a result of this interest rate to earnings yield comparison. It's just a valuation methodology. Until such time as we receive cash dividends from the company (dividend yield is not to be confused with the earnings yield) or realize cash by selling the stock, we won't realize actual cash. Our stock returns will be "unrealized". It's also key to our understanding that we know that if the company in fact earns more or less than the assumed $6 or if the interest rates generally increase or decrease, the comparative bond vs. stock calculation will change as well. Today we have a considerable valuation cushion favoring stocks.
Thus, we use this earnings to bond yield comparison as a general but important benchmark when deciding whether the general equity market is currently attractive. As a point of information, the S&P 500 at ~1340 presently with anticipated earnings of ~$95 this year would indicate that the market is undervalued. If earnings come in closer to $100 for the year or interest rates were to decline from present levels, that would make the case for stocks even stronger.
But what about the longer range picture? While the economy may well struggle somewhat for the next few years due to the elephant in the room debt issue, earnings should still increase nicely. Compared to the low interest rates in effect now and for the foreseeable future, that makes stocks the more compelling choice. And if the economy picks up the pace sooner than later, so much the better.
At a later point we'll go into more detail about the debt dilemma and its impact, as well as why the earnings outlook for companies is better than the outlook for the U.S. economy.
Thanks. Bob.
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