One of the great joys of working at GMO is the freedom to disagree. Indeed, many moons ago when Ben Inker first approached me about joining GMO, he told me that, having read my work, he believed we were very much philosophically aligned. Ben noted, however, that occasionally I would reach a remarkably different conclusion than he, and that was interesting because we obviously approached problems using a very similar framework.
Over the years, Ben’s observation has consistently revealed that at times the most valuable information can be found in our differences, and not in the areas in which we all agree. As the late Richard Russell opined, “If everyone is thinking the same, then no one is thinking.” Or, as Alfred P. Sloan put it, “If we are all in agreement on the decision – then I propose we postpone further discussion of this matter until our next meeting to give ourselves time to develop disagreement and perhaps gain some understanding of what the decision is all about.” Indeed, one of my jobs internally is to ask difficult questions and take the other side of debates when I feel so inclined: a contrarian amongst contrarians. It turns out that I’ve pretty much been in training to be a stubborn, difficult pain in the arse my whole life! Introduction In GMO’s 3Q Letter, Ben wrote the following: But it is difficult to dismiss the possibility that this time actually is different. While all periods in which asset prices move well away from historical norms on valuations have a narrative that explains why the shift is rational and permanent, I would argue that this time is more different than most. Whether we are talking about 1989 in Japan, 2000 in the US, or 2007 globally, what bubbles generally have in common is that the narratives require the suspension of some fundamental rules of capitalism. They require either large permanent gaps between the cost of capital and return on capital, or some group of investors to voluntarily settle for far lower returns than they could get in other assets with similar or less risk. Today’s market has an internal consistency that those markets lacked. If there has been a permanent drop of discount rates of perhaps 1.5 percentage points, then market prices are generally close enough to fair value that you can explain away the discrepancies as business as usual.
In GMO’s 3Q Letter, Ben wrote the following:
But it is difficult to dismiss the possibility that this time actually is different. While all periods in which asset prices move well away from historical norms on valuations have a narrative that explains why the shift is rational and permanent, I would argue that this time is more different than most. Whether we are talking about 1989 in Japan, 2000 in the US, or 2007 globally, what bubbles generally have in common is that the narratives require the suspension of some fundamental rules of capitalism. They require either large permanent gaps between the cost of capital and return on capital, or some group of investors to voluntarily settle for far lower returns than they could get in other assets with similar or less risk. Today’s market has an internal consistency that those markets lacked. If there has been a permanent drop of discount rates of perhaps 1.5 percentage points, then market prices are generally close enough to fair value that you can explain away the discrepancies as business as usual.
In this paper I will lay out why I disagree with this viewpoint. For those wondering about the title I chose, it comes from Through the Looking-Glass, and What Alice Found There, which I have been reading to my daughters of late.
Alice laughed: “There’s no use trying,” she said, “one can’t believe impossible things.”
“I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”
I believe the markets are behaving like the White Queen. In order to make sense of today’s pricing, you need to believe in six impossible (okay, I’ll admit some of them are just very improbable as opposed to impossible) things.
1. Secular stagnation is permanent and rates will stay low forever. As we have argued at length elsewhere, secular stagnation is a policy choice and we could exit it reasonably quickly by implementing appropriate policies.
2. The discount rate for equities depends on cash rates. This is nothing more than a belief. It has no foundation in data and not a scrap of evidence exists that supports this hypothesis.
3. Growth rates and discount rates are independent. This is a very questionable assumption. If, as I believe, it is false, then it makes the “Hell” outcome Ben has discussed in previous Quarterly Letters less likely, unless the first two beliefs hold completely.
4. Corporates carry out buybacks ad nauseum, raising EPS growth despite low economic growth. This would imply rising leverage, which is already close to all-time highs. Remember Minsky: Stability begets instability.
5. Corporate cash piles make the world a safer place. Cash levels aren’t high by historic standards, and valuations are extreme even when cash is fully accounted for.
6. The “Hell” scenario is the most probable outcome. This requires “this time is different” to be true and, unlike Jeremy Grantham, I am not yet ready to assign this exceptionally useful rule of thumb to the waste bin of history. Put another way, Hell requires that stock prices have reached a “permanently high plateau,” and I’m not about to embrace that statement.
A world priced for secular stagnation forever
As Ben Graham wrote long ago, “The principles of common-stock investment may be closely likened to the operations of insurance companies.” I would broaden his statement from “common-stock” to “all” investment. Market prices can be thought of as embodying a set of beliefs about the future. Thus, we can cast investing as assessing the implied view of Mr. Market, and then work out where we disagree with it. To this end I often suggest starting with understanding what the market is currently “pricing in.”
When I look around today, I see a world priced for secular stagnation (low growth, low inflation). Let’s start, for example, with the government bond market. Exhibit 1 shows the average real rate implied by various 30-year government bonds depending upon the assumption one chooses to make regarding the level of the term structure.
If one assumes that 30-year bonds should carry around 100 bps of term premium over cash (which is roughly what Japanese 30-year bonds have displayed since they reached zero cash rates), then bonds imply that the average real cash rate over the next 30 years will be somewhere between -50 bps and -250 bps depending upon the market chosen.
Now, perhaps you think 100 bps of term premium is too steep. I also ran the numbers assuming a zero term premium. The range of implied real rates shifts naturally but remains extraordinarily low by any standards, ranging from a positive 50 bps to around -150 bps. In either case, it is safe to say that the major government bond markets are priced for secular stagnation.
Exhibit 1: Implied Real Rates Over 30 Years
As of Jan 2017
We can compare this to the limited data available on periods of financial repression (when interest rates are held below the rate of inflation). As shown in Exhibit 2, the average period of financial repression (to the extent that average makes any sense in this context) is 22 years ±12 years. The average real interest rate during those periods was -70 bps. Thus, many bond markets today seem to be implying both a longer and deeper period of negative real rates than the average historical experience.
Exhibit 2: Average Duration of Financial Repression
Source: Reinhart and Sbrancia, DMS
One thing to note that truly is different this time is that past periods of financial repression have generally been achieved with high(ish) inflation. This is the first time we have seen low inflation and the use of negative nominal interest rates in the case of some central banks.
As a quick aside on negative nominal interest rates, they are almost certainly not going to aid in any economic recovery. Of course, as regular readers will know, I subscribe to the view that interest rates generally don’t matter that much within the economy.1 However, even if you don’t agree with me on the general impotence of interest rates, we can agree that negative nominal interest rates are simply a tax. Now, don’t get me wrong. I have absolutely no problem taxing banks. But thinking that the imposition of a tax is going to aid economic recovery is simply beyond my comprehension. Just recall that in a circular flow of income (macro 101), taxes are one of the leakages.
The pricing of government bonds to reflect the certainty of secular stagnation seems odd to me. As I have written before, secular stagnation is a policy choice.2 We have both the tools and knowledge to end secular stagnation tomorrow if we collectively choose to do so. Contrary to conventional wisdom, monetary policy isn’t the route out of our current problems. Monetary policy is really all about the redistribution of net worth between creditors and debtors. If secular stagnation is really about low growth and insufficient demand, then fiscal policy is the answer. Fiscal policy alters the level of an individual’s net worth.
Of late, the concept of helicopter money has gained a certain degree of popularity. From my perspective, helicopter money is really just fiscal policy carried out by the central bank. It has the same effects as a fiscal expansion in that it raises the level of net worth for the private sector. So, should such a policy ever be tried, it is likely to be successful – although why one would want fiscal policy run by unelected technocrats is beyond me. However, the basic point here is that markets priced for secular stagnation are putting a zero probability on fiscal policy being used as a route out of our current malaise.
If bond markets are smoking weed, then the stock market appears to be hooked on crack. Exhibit 3 is a way of reverse engineering the equity markets’ beliefs about interest rates. It is based on a simple dividend discount model (DDM) that I first used to explore financial repression and its impact.3 The idea is to show how long we would need to see -2% real interest rates, assuming a normal equity risk premium, in order to justify today’s S&P 500 valuation as “fair.” A cursory glance at Exhibit 3 indicates that we would need to believe that real rates of -2% real for 90 more years would be necessary in order to reach the conclusion that today’s market valuation is fair! This would be a 6-standard-deviation event even in a world rife with financial repressions, and strikes me as another near impossible thing that investors are embracing as a certainty.
Exhibit 3: Number of Years of -2% Real Rates To Justify S&P Valuation as Fair
As of Jan 2017
Discount rates driven by cash rates?
The model I used to frame this analysis has two key assumptions, neither of which I find very palatable. The first assumption is that the discount rate used for equities should be a function of the interest rate, which I’ve discussed in a previous paper.4 To provide the briefest of recaps, the idea that the discount rate (which should reflect your required return on equity investing) is a function of the interest rate is an assumption, nothing more and nothing less. It may seem innocuous enough, but I have serious misgivings about its grounding in reality.5
In fact, I can find no evidence of a relationship between real interest rates and valuations. Consider Exhibit 4, which plots the perfect foresight real interest rate over 10 years (that is to say, if one could predict with perfect certainty both the nominal interest rate and the inflation rate over the next 10 years – a feat beyond mortal man for sure) against the Shiller P/E. If low real rates did indeed co-exist with high valuations, we would see the data points line up on a 45-degree line sloping downwards from top left to bottom right. Low rates would coincide with high P/Es, and low P/Es would coincide with high rates. However, the data indicates something quite different. At best, we see no relationship; at worst, a line of best fit would show a positive relationship. This is obviously at odds with the idea that the real interest rate determines valuation, and thus also at odds with the assumption that the discount rate for equities should be a function of the interest rate.6 I know that it seems to be utterly believable that the two should be related, but there isn’t a shred of evidence to support this view.7
Exhibit 4: Tell Me Again that Real Rates Drive Valuations
As of Jan 2017