Dear TINA, We Need to Talk
“There is no alternative”. Those words have become one of the main pillars of the dominant narrative of Western equity markets.
For years, interest rates have only gone south because of central banks’ ultra-accommodative policies. Thus, Wall Street loves to state that investors do not have the choice but to increase their exposure to risky assets in order to generate more yield. Going further, many professionals claim that US equities are cheap relatively to the level of rates.
However, it is more complex and not entirely true.
No Free Lunch
People should be cautious considering the absolute level of interest rates in Western economies, and especially when using them to discount assets like stocks. First, because one could regard those rates as artificial, as they are the result of intensive money printing decisions. In other words, ZIRP or NIRP do not indicate the real level of risk of the issuing governments, as such monetary measures tend to fragilize the currency of the bond on a long-term horizon.
Second, because zero rates are the corollary of future low economic growth, meaning that one should not expect significant economic value creation in such an environment. Besides, ultra-dovish policies tend to increase moral hazard, favoring problematic asset inflation and capital misallocation, leading to financial imbalances (see There Ain’t No Such Thing as a Free Lunch – Part 1 and There Ain’t No Such Thing as a Free Lunch – Part 2). Therefore, the marginal impact of MMT on the economy becomes less and less positive.
One should take all those factors into account when estimating the cost of capital of a firm.
Beyond that, it is important to realize that low rates do not mean that risky assets have become affordable.
I keep hearing that the Nasdaq is not that expensive if you consider the level of rates and the fact that growth stories have become rare. While price-to-earning ratios are skyrocketing, people love to cite the equity risk premium to justify the cheapness of tech stocks. Sometimes, they use the so-called “earning yield” (though not really significant from an economic perspective), and compare it to the yield of long-term sovereign bonds (e.g. US 10 years Treasury note).
Currently, the S&P 500 forward PER suggests a yield of 3.9%, which is far superior to the 10 years yield (0.7%). Even the CAPE Shiller PER leads to a greater yield (3.3%). Fair enough.
But this is analysis is misleading. Indeed, as rates have been decreasing for years, current yields do not reflect the actual performance of bonds since the introduction of QE. Before considering stocks as alternative, investors should remember that as long as central banks keep on expanding their balance sheets, bonds prices are likely to rise. Somehow, the drop in recurrent revenues is offset by a long-term gain on mark to market basis.
Considering iShares US Treasury bonds ETF as a proxy, the average annual return of 10 years “risk-free” assets is close to 3.4% for the past ten years, and the return of 20 years bonds is 6.9%. From that perspective, US equities are not necessarily that cheap, with a level of risk definitely higher.
Of course, one could argue that such a reasoning assumes that QE will increase to infinity. Well, hasn’t the Fed announced that a few months ago? What is more, imagine that a major central bank decides to stop its balance sheet expansion. Then, what will happen? Of course, bonds prices would drop, but we all know that equities will crash. Therefore, you can only assume stocks to rise if interest rates keep on decreasing, and from that perspective, it is misleading to state that stocks have become affordable.
The truth is that stocks have never been so expensive on a fundamental basis, whether you consider the total market capitalization to GDP ratio or the CAPE Shiller price-to-earnings ratio.
The same misperception exists for real estate investment. People believe that lower mortgage rates are synonyms of cheaper property. Of course, it is not true and affordability indices in hot places like Bay Area or New York City are at record low levels, meaning that it has never been so difficult to buy a home with the average annual income.
“Cash Is Trash” – Ray Dalio
There is no alternative, right? Cash is trash. And of course, this time is different.
Well, the only real difference today is the fact that Warren Buffet is now investing on gold. So, there might be a few alternatives.
But Wall Street needs to generate revenues. So, let’s convince everyone to take the blue pill and to believe that TINA is for real. Even during the worst recession since the 1930’s.
Somehow, it is not that far away from Dave Portnoy’s “stocks only go up” fantasy.