The Money Enigma – December 1, 2015

• There is a widely held view among equity investors that the S&P500 can hold its ground and possibly manage small gains in 2016 provided that the US economy continues to recover. While nearly all market strategists recognize that rising interest rates will create a “headwind” for the market in 2016, most of those strategists will argue that the stock market can hold its own provided that the economy remains robust.

• The view of The Money Enigma is that this optimistic assessment ignores the fundamental principles of equity valuation. The value of any business is far more sensitive to its required cost of capital than to any near-term earnings potential. Therefore, as the Fed “normalizes” monetary policy and, in effect, raises the required cost of capital for all businesses, the negative impact on stock prices will far outweigh any positive benefit associated with a stronger economy.

• Does this mean that equity investors should hope for a weak economy in 2016? It is certainly true that a weak economy in 2016 may delay the process of monetary policy normalization and thereby provide continued support to the global equity markets. However, a weak economy creates its own set of risks.

• While many investors will worry about the impact of a weak economy on near-term earnings, the real issue that investors should focus on is how a weaker economy might impact long-term expectations regarding the future economic prosperity of the United States.

• There are two reasons that equity investors should worry about how a recession might impact expectations regarding the long-term future of the United States. First, stock valuations are highly sensitive to expectations regarding long-term earnings growth. Second, and less obviously, the inflation rate is highly sensitive to expectations regarding the future of the United States.

• If a weaker economy in 2016 damages long-term economic confidence, then this could precipitate a marked fall in the value of the US Dollar and a sudden rise in prices. A sudden surge in the rate of inflation combined with increased uncertainty around long-term earnings growth would spell disaster for the US equity market, particularly given the current state of elevated equity valuations and positive sentiment.

A Strong Economy is Good for Stocks, Right?

Conventional wisdom used to be that a strong economy is good for stocks and a weak economy is bad for stocks. But it seems that times have changed. The equity market treads water on good economic news and surges on bad economic news. So, what type of economy should equity investors hope for in 2016?

In order to answer this question, it helps to go back to fundamentals. More specifically, it helps to think about what makes a business valuable: the sum of its discounted future cash flows.

There are a couple of basic arguments to support the notion that a strong economy is good for stocks. First, a strong economy supports near-term earnings. This factor is particularly important for companies that have been struggling to generate profits and pay down high levels of debt.

Second, a more importantly, a strong economy tends to reinforce and promote optimistic expectations regarding the long-term future of the economy.

While most Wall Street analysts are obsessed by near-term earnings, the fact of the matter is that the stock market’s valuation is, at least theoretically, far more sensitive to expectations regarding its long-term earnings potential than its earnings in the next quarter. At the margin, a strong economy will tend to make investors more optimistic about the long-term earnings potential of the market and provide support to stocks. This rise in long-term confidence tends to be far more important to the market as a whole than any actual improvement in near-term term earnings.

The problem with our analysis so far is that ignores another simple but critical idea: the value of a business is determined by the sum of its discounted future cash flows. While a strong economy may promote confidence regarding future cash flows, we also need to consider how a strong economy may impact the discount rate that is applied to those future cash flows.

In today’s world of hyperactive monetary policy, markets tend to believe that a strong economy is bad for stocks and a weak economy is good for stocks. Why? Well, in simple terms, a strong economy encourages the Fed to tighten monetary policy, thereby raising the risk-free rate and consequently the required cost of capital for all businesses. In contrast, a weak economy encourage speculation that the Fed will maintain the current level of very low long-term interest rates, thereby pegging the long-term cost of capital at a low level.

It should be noted that this wasn’t always the case. Indeed, it is worth thinking about what has changed over the past thirty years.

In simple terms, prior to the current period of Fed hyperactivity that began with the introduction of QE1 in 2008, it can be argued that Fed policy had relatively minimal impact on the real long-term risk free rate and, therefore, a fairly small impact on the long-term cost of risk capital.

Prior to 2008, the Fed focused most of its efforts on controlling short-term interest rates. This manipulation of short-term interest rates did have a significant impact on bank lending activity and it certainly had some impact on the shape of the yield curve, but arguably the Fed’s interference in the long-term interest rate market was fairly minimal.

Why does this matter to equities? It matters because it is the long-term cost of risk capital that drives stock valuations and, one can argue, that prior to 2008, the Fed had very little direct involvement in setting this benchmark.

However, in 2008/2009, the Fed decided that the manipulation of short-term interest rates wasn’t enough. Therefore, the Fed started to explicitly manage long-term interest rates by creating money and buying long-term government securities, a policy known as “quantitative easing”.

Suddenly, the Fed plays a critical role in the determination of stock valuations and, therefore, a critical role in driving stock market direction. Whereas pre-2008 Fed policy was analyzed largely for the impact it would have on future cash flows, i.e. would Fed policy stall the economy, post-2008 we can see that Fed policy has a critical impact on both future cash flows and the long-term interest rate used to discount those future cash flows.

This combination of factors has created much confusion in the equity markets. In particular, it has led to confusion regarding whether a strong economy is good for stocks.

Long-Term Cost of Capital Trumps Near-Term Earnings

As mentioned at the beginning of this week’s article, there is a view among many Wall Street equity market strategists that the equity markets will be OK in 2016 provided that the US economy continues to recover. Their view is that improving earnings will offset any normalization of monetary policy by the Fed in 2016.

The view of The Money Enigma is that this perspective either demonstrates a lack of understanding regarding the key drivers of stock valuations or that these strategists are making rather optimistic assumptions about the path and timing of monetary policy normalization.

The key problem for the US equity market is that the long-term cost of capital used to discount future earnings is far more important than any improvement in near-term earnings. If the Fed begins to normalize monetary policy and the long-term interest rate rises, then this will have a profoundly negative impact on stock valuations.

Moreover, we know from a mathematical perspective that this negative impact will far outweigh any positive impact on valuations from an improvement in near-term earnings associated with a stronger economy. Stocks are long-duration assets and their valuation is far more sensitive to changes in the long-term discount rate than any change in near-term earnings.

Therefore, if a stronger economy does encourage the Fed to normalize monetary policy, then this will have a profoundly negative impact on stock valuations and overwhelm any improvement in near-term earnings.

However, a strong economy isn’t necessarily bad news if the Fed raises short-term interest rates but is careful to keep a lid on long-term interest rates. In other words, if the Fed raises the Fed Funds rate but uses its balance sheet to keep long-term interest rates at current low levels, then the equity market may be able to eek out another year of gains as earnings growth continues and the Fed continues to overly manipulate the long-term cost of risk capital.

For equity investors, this is probably the best near-term outcome. However, this “let’s pretend to normalize policy” path by the Fed does pose long-term risks. As discussed in previous posts including “The Case for Unwinding QE”, the Fed must eventually normalize the size of the monetary base (the Fed balance sheet) or it risks triggering a sharp devaluation in the US Dollar and resurgence in inflation.

In summary, a strong economy in 2016 will probably force the Fed to do something. Whether this action by the Fed will hurt the equity markets will depend on largely how aggressive the Fed is and, more importantly, whether it genuinely begins the normalization process or merely pretends to, i.e. raises short-term interest rates but continues to manipulate long-term interest rates.

Is a Weak Economy is Better for Stocks?

If a strong economy is likely to produce an adverse outcome for stocks, then should equity investors be praying for a weak US economy in 2016?

In the previous section we argued that a strong economy was bad for stocks because the negative impact of a rising cost of capital would overwhelm any positive impact from stronger near-term earnings. Therefore, if we simply reverse the logic, a weak economy should be good for stocks, right? Although there may be a hit to near-term earnings, this weakness will be mostly offset by hopes for a further reduction in the long-term risk free rate, i.e. more QE!

Superficially, this argument is fair. Indeed, it may be the case that this is exactly how events unfold. A weak US economy in 2016 puts the Fed on hold, thereby supporting the equity market at its current lofty valuation level.

The problem with this rather simplistic analysis is that doesn’t consider how a weak economy in 2016 might impact long-term expectations regarding the future of the US economy and the long-term earnings growth potential of corporate America.

While a strong economy in 2016 is unlikely to improve already optimistic expectations regarding the long-term future of the United States, a weak economy in 2016 could damage investor expectations regarding the long-term health of America.

In general, a weak economy should not represent sufficient cause in and of itself for a major rethink by investors regarding the long-term economic prospects of society. But the view of The Money Enigma is that a major recession in 2016 could trigger such a review. Why? Well, if a recession did begin in 2016, then it would be the first time that a recession has begun without any attempt by the Fed to raise interest rates or normalize monetary policy. In other words, investors may begin to feel that the Fed has missed the boat and they may begin to question the underlying structural health of the United States.

If a weak economy in 2016 damage optimism regarding the long-term economic future of the United States, then this could hurt equity prices in two ways.

First, and most obviously, if investors begin to believe that the economy will grow at a slower rate than previously expected over the next 10-20 years, then investors will be forced to lower their expectations regarding the long-term earnings growth rate for the market.

Historically, companies in the S&P 500 have grown their earnings per share at a rate of about 6% per year. However, if investors become more pessimistic about the long-term prospects of the economy, then they may need to lower this expected earnings growth rate, particularly given the current elevated level of corporate profit margins (see John Hussman’s work for more details on this point).

In theory, this lowering of long-term earnings growth expectations will have a much greater negative effect on stock prices than any near-term weakness in earnings that would ordinarily occur in a recession.

The second factor that could have a major negative impact on stock prices is more complex. In essence, the view of The Money Enigma is that the value of fiat money is inversely correlated to optimism regarding the long-term future of society. Therefore, if investor optimism regarding the long-term future of the United States is damaged, then the value of the US Dollar will fall and prices, as expressed in US Dollar terms, will rise.

In other words, a weak economy in 2016 could be the trigger for a sudden increase in the rate of inflation. Such an outcome could be devastating for equity markets that are priced to achieve low nominal expected returns, at least by historical standards. Moreover, a sudden increase in the rate of inflation in 2016 would definitely catch the Fed off guard and hurt the confidence of both bond and equity market investors.

Inflation and Long-Term Expectations

The consensus view among economists is that inflation in the US will only occur if the economy is strong. Moreover, most economists believe that a weak economy poses a greater risk of deflation than inflation. This quintessentially Keynesian view of inflation is terribly flawed and represents one of the great economic myths of our time.

The simple fact of the matter is that historical evidence indicates that episodes of high inflation (10%+ inflation) are more commonly associated with weak economic conditions than strong economic conditions as discussed in a recent post titled “Does Excess Demand Cause Inflation?”

The theoretical foundations for this phenomenon are complex but, in essence, the problem with the traditional Keynesian view of the world is that it only considers one part of the picture. Keynesian economics focuses on the impact of a recession on the market value of goods. But it forgets on key thing: every price is a relative measurement of two values. More specifically, every price in money terms is a relative expression of both the value of goods and the value of money. If a recession triggers a fall in the value of money and if that fall in the value of money is greater than the fall in the value of goods, then prices as expressed in money terms will rise!

The view of The Money Enigma is that the price level is a function of two values: the market value of goods and the market value of money (see “Ratio Theory of the Price Level”). The key to representing the price level in this way is isolating both variables by measuring each in terms of a “standard unit” of market value, an idea is discussed at length in “The Value of Money: Is Economics Missing a Variable?”

While economic weakness will almost certainly have a negative impact on the market value of goods (the numerator in our price level equation above), the view of The Money Enigma is that economic weakness can also impact the value of money (the denominator in our equation).

More specifically, the problem with recessions in fiat money regimes is that they can trigger a sudden collapse in the value of money. Why? Well, in simple terms, fiat money is only as good the society that issues it. More specifically, the value of fiat money is primarily determined by long-term expectations regarding the future economic prosperity of society. If that confidence is suddenly undermined, then the value of money can fall precipitously.

Prolonged economic recessions have a nasty habit of highlighting the key structural weaknesses of an economy. If next year turns out to be a much more difficult year for the US economy, then this could remind investors that the United States faces several long-term structural challenges, most notably its continued reliance on rising government debt and persistent deficits.

If economic weakness in 2016 does trigger a collapse in long-term economic confidence, then the results could be devastating for both the US Dollar and US equity markets. More specifically, a slump in long-term confidence could lead to a sudden jump in the rate of inflation and a decline in long-term earnings growth expectations. This combination would spell disaster for a stock market that is priced for perfection.

In summary, the best hope for equity investors in 2016 is that things continue much as they have done in 2015: the US economy muddles along and the Fed remains on hold. The problem is that the clock is ticking on this “new normal”: the Fed must normalize monetary policy eventually and, as it does, the US economy must demonstrate that it can grow without the Fed acting as life support.