The 3 Ps: Productivity, Population, and ‘Product’ – Part 1

Back in 2009, a brilliant economist, author and Harvard professor, Carmen Reinhart, co-authored a book entitled “This Time is Different:  Eight Centuries of Financial Folly.”   Even if you don’t read this book in its entirety, it is an iconic read, well worth a quick review by anyone concerned about the amount of sovereign debt developed nations are piling on these days.   (Rest assured, we’ll revisit this topic again in future blogs.)

Professor Reinhart and her partner analyze over 800 years of financial crises, noting that each crisis was preceded by the ‘talking-head experts’ of that time opining that old rules don’t apply, that this time is truly different.   Of course, history has proven those experts wrong time and time again.   Professor Reinhart’s book makes this fact patently clear.

But, at the risk of becoming one of those talking heads later proven wrong, I contend something is very different today.    Specifically, demographic trends, the efficacy of labor, the impact of both on current and future GDP trends, and, finally, the implications of these long-term trends on investment asset values.

Let me explain.

Why you Should Care:   If I’m right, many if not most of the official US GDP forecasts and expectations need to be revised.  Downward.

For example, on June 15th FED members collectively forecasted real GDP will grow about 2% this year and 2017, possibly dipping slightly in 2018, and in the “longer run” grow between 1.6% and 2.4% per year.   If I’m right, even this paltry forecast could be overly optimistic.  (Here is the FED members latest forecast:  https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20160615.pdf)

And the consensus forecast for inflation is too high.   US inflation is unlikely to approach or exceed 2% for a long, long, long time.   (Housing expense is one area where we can definitely expect inflation…this component will continue to elevate the PCE and CPI.)

If I’m wrong, good.   I’d prefer that outcome.   That would be better for everyone.   But I don’t think I am.

Taking Action:   The rate of return on investment is a paramount concern to everyone.   Whether you’re an individual, a business, an investor, an insurance company, a pension fund or … whatever, the rate of ROI is critically important.

Future ROIs will be lower than ever before in history.   And they will remain low – for a very long time.

Meaning the value of the assets that produce that return will move in an inverse direction – UP.   The value of their income streams is increasing.   Dramatically.  This dynamic is presently at work in the stock and bond markets.   And the real estate markets.

Real and financial asset values are rising.  And will continue to do so.  If you have the opportunity to acquire well positioned assets, do so.   As soon as possible.  Values are likely to continue to rise.

The BLOG:   Predicting the future is a daunting task.   I’m probably no better at it than you are.

But sometimes we find data trends that appear overwhelmingly indicative of likely future events or outcomes.   And while these outcomes are not certain, if the analysis is objective and incorporates accurate data, the probability of the predicted outcome increases.

The value of an asset is some function of its income.    The larger, more predictable (consistent), and longer-lasting that future income is, the higher the value of the underlying asset.   However, there’s another factor that looms large in this analysis:  the discount rate.

This is the rate used to “discount” future cash flows into today’s dollars.   For example, suppose I agree to give you $100 in exactly one year.   Or, if you prefer, I’ll give you $91 today instead.   Which do you pick?  How do you choose?

Well, being an astute investor, you’d take this approach:  if you could invest that $91 I gave you today and have more than $100 in one year, you’d take the $91.  You would have to earn about a 10% annual return to equal $100 in a year.  If your ROI is less than 10%, you’d take my $100 in a year.  And the opposite is true.   The ROI is effectively your discount rate.

Alternatively, say I agreed to give you $100 per year, now and each anniversary, for the next 4 years?  What is that income stream worth today?  The answer is called the ‘present value‘.   If you google present value, you’ll find this formula for one single future payment:

… where “C” is the cash payment you’ll get in some future year (in our example, $100) and ‘n’ is the year in which you receive it.   Simple, right?  🙂

Let’s do the example.  We simply use our discount rate – let’s say it’s 10% – and discount each annual payment back to today.    Then add ’em all up and that’s your value – today.  Here’s the math:

• Today (actually, year 0):  $100 – worth $100.
• Year 1:  $100 divided by 1.10 = $90.91
• Year 2:  $100 divided by 1.21 = $82.64  (the 1.21 is simply 1.1 compounded for 2 years)
• Year 3:  $100 divided by 1.33 = $75.13  (the 1.33 is simply 1.1 compounded for 3 years)
• Year 4: $100 divided by 1.46 = $68.30

Thus, this income stream is worth $416.98 if we use a 10% discount rate.   How about if we use a lower rate, say 5%?   Is this income stream worth more or less?

Quite a bit more.  $454.58.   And if we use a 3% discount rate?   $471.70.

It’s easy to see, then, that the value of an income generating asset INCREASES as market participants expect lower and lower rates of ROI.   This is precisely what we’re experiencing today.

It’s important to note some very smart and successful people think assets are already overvalued.   They are concerned we might be in bubble territory.  Even the FED has expressed concern.

For example, famous and iconic investor Carl Icahn, is betting the stock market is overvalued and values will be falling.   He’s betting big bucks on this outcome.  Could he be right?  Sure.   But I don’t think so.

Equally concerning, on June 21st, the FED presented their semi-annual Monetary Policy Report to Congress.  Here’s the URL if you’d like to read the entire report.  It’s actually quite good and worth a read:

http://www.banking.senate.gov/public/_cache/files/604369c8-927e-4933-8b5c-c2a48a547fcd/B1761939A978289FE81C0F8931F9FDAF.062116-monetary-policy-report-june-2016-final-2-.pdf

The following is an excerpt from page 21 of the report:

“Forward price-to-earnings ratios for equities have increased to a level well above their median of the past three decades.  Although equity valuations do not appear to be rich relative to Treasury yields, equity prices are vulnerable to rises in term premiums to more normal levels, especially if a reversion was not motivated by positive news about economic growth.

Valuations in the CRE (commercial real estate) sector appear increasingly vulnerable to negative shocks, as CRE prices have continued to outpace rental income and exceed, by some measures, their pre-crisis peaks. However, leverage in the sector does not appear excessive, and some evidence points to a recent reduction in risk appetite among CRE investors. overall growth of CRE debt is moderate, and the ratio of debt backed by nonfarm nonresidential property to GDP is below an estimate of its long-run historical trend.”

Permit me a few quick interpretations and comments:

• The FED is suggesting stock values, in general, are above the level we would expect at the P/E ratios common and consistent in the past 3 decades.   This is a relatively accurate statement.

Ignoring the aberrational spike in 2008/2009 – the result of rapid corporate earnings declines – it’s easy to see today’s P/E ratio average of around 24.1 is on the high side.

• Conversely, interest rates have also fallen significantly in the past 3 decades.  One can argue if rates remain at or near these historic lows, P/E ratios should be higher than historic norms.   Here’s a chart showing movement in the 10-year treasury.  Over 10% in 1987 – 30 years ago – the 10-year T is now very near 1.5%.

• The FED is suggesting CRE – commercial real estate values – might be frothy.   Again, perhaps.  But in light of the massive and long-duration interest rate declines, we can argue current interest rates are, effectively, the discount rate we should use to value the income streams from CRE.  Taking that approach, prices may actually be quite low.

So, is it different this time?   If mid- and long-term interest rates stay at or near present levels for a protracted period of time, are today’s ‘frothy’ P/E ratios and CRE valuations supported?  Do P/E ratios in the low to mid 20s make sense?   Do low, low capitalization rates for CRE make sense?

I believe they do.  GDP growth will remain at or below 2% for many years.  As a result, interest rates will also remain at these low, low levels for years to come.  Meaning both financial and real assets are fairly valued today – and may be actually be cheap.

In my next blog – Part 2 – I’ll explain why.

• Terry Liebman