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Bill Gross said it well in his recent investment outlook, “As it is, in 2015, I merely have a sense of an ending, a secular bull market ending with a whimper, not a bang. But if so, like death, only the timing is in doubt. Because of this sense, however, I have unrest, increasingly a great unrest. You should as well.”
Bill Gross believes the bull market in debt and equity of the last 30+ years is soon coming to an end, and his belief seems to be predicated primarily on one fundamental question: “Where can zero percent and negative percent interest rates go from here?”
Stocks, bonds, real estate, and other asset classes around the world are all being priced based on the lowest interest rates the global economy has ever seen. If discounted cash flow models are being built around the assumption of zero percent interest rates, this results in peak DCF values that can only go down as interest rates go back up. Likewise, if home buyers are pricing real estate based on the affordability of their 4% 30 year mortgage, then, home prices can only go down as this mortgage rate creeps higher.
Mr. Gross does overlook one key fact in the pricing of stocks, however, which is that long-term DCF models should implicitly assume that interest rates will normalize in the out years. Therefore, DCF values have room to run higher if the Fed decides to never normalize interest rates. This is why Buffett said stocks may indeed turn out to be cheap if zero percent interest rates stick around for the next 5-10 years.
Like I’ve mentioned in this prior post, at the end of the day, all that matters for stock markets in the long-run is S&P 500 earnings. And interest rates are a powerful factor that goes into determining the price / earnings multiple that investors will pay for that level of S&P earnings. If interest rates normalize, then, mathematically, we have a problem in the stock market. S&P 500 earnings will be hurt by higher interest expense, less corporate buyback ability, and less consumer demand from the decrease in cheap financing sources. And ultimately, when S&P earnings growth decreases, investors ascribe a lower valuation multiple due to this lower growth rate.
The trickier question is what happens to the stock market if the Fed keeps interest rates at zero for the next 5-10 years. Yes, it is entirely possible that the stock market will continue rising as investors price in more buybacks, more refinancing of high cost debt, and continue to award high multiples of growth for S&P earnings. However, at some point, investors will want to know if the economy is still growing or not. No level of financial engineering can save the stock market if economic growth begins slowing down, and consumers and corporations slow their level of spending.
And this is where I ultimately believe we are headed regardless of the direction of future interest rates – painfully slow economic growth. Zero percent interest rates do not create economic activity out of thin air. Instead, it borrows economic activity from the future. This borrowing of economic activity from the future can continue to occur for a long time until the borrowing capacity of consumers and governments become tapped out.
As I discuss in this prior post, I now believe that the US consumer and US government are leveraged to the hill and simply cannot afford to borrow more and spend more, which is why the US economy continues to put up disappointing economic numbers quarter after quarter.
With stocks, low growth rates are highly correlated with low valuation multiples, and high growth rates are correlated with high valuation multiples. In today’s equity markets, we currently have high valuation multiples (17.0x forward S&P earnings) for low growth rates since investors continue to believe in the vision that economic growth is just about to reach “escape velocity.” If I am correct about the effect high debt levels have on future spending, then, the stock market valuation multiples will ultimately have to adjust to the reality of perpetually low economic growth rates regardless of which way interest rates move in the future.