Our FRB: Helpless, Hopeless And Superfluous
The fortress façade of the Federal Reserve building in Washington D.C. should be remodeled into a glass exterior. Then, we could see who’s asleep there. Never thought I’d see our FRB praying fervently for 2% inflation. Conceptually, they believe you need some inflation expectations to maintain GDP growth. Absent inflation, the consumer defers purchases while the corporate sector stretches out capital spending, what they call gross private domestic investment.
This is inborn insanity of economists. They say there are 400 of ‘em at work in Washington. I’d pare this down to a half dozen. They would probably do less damage, cycle-over-cycle. With 30-year Treasuries trading under a 2% yield, and two-year paper at 1.09%, the country really should be celebrating low-interest rates.
Even Tesla and Boeing can get huge traunches of bond money on the cheap. Prospective home owners obtain 3.5% mortgages. Actually, I’m down to 3% for the next nine years. Prospective car buyers find cheaper loans, too. Homebuilders and auto sales rates can benefit from such largesse.
The “cost of carry” is a bedrock financial yardstick for valuation ranging from margin credit to multibillion financing for commercial real estate projects, even iconic art pieces – all tied to borrowing costs. Barring capacity to raise capital at a reasonable-economic rate of interest, there wouldn’t be private equity operators flexing their muscles, using leveraged financial constructs in their multi-billion dollar deals.
Aside from earnings power, interest rates contain the most potent variable determining the price-earnings ratio of the market. Over our entire postwar history, the Federal Reserve Board’s intervention impacted business cycles and the course of the market, mainly in a negative way. The Board’s failure to reign in speculative home mortgage credit from our banks birthed the financial meltdown of 2008-2009.
Paul Volcker didn’t even blush when raising interest rates to 15% in 1982 to rid the country of its inflationary expectations. The stock market sold down to book value and yielded 5%, bottom of cycle. Today, the Big Board sells at two times book and yields under 2%. Plenty of room for more sell-off just based on historical valuation comparisons. Employing my normalized earnings projection in 2021 of $180 a share and putting a 15 multiplier on the S&P 500 Index, the market counts up to just 2,700, still 10% overvalued.
I delved back into financial history to find when the market sold at 18 times earnings or better. But, first, lemme say that a century’s worth of market stats show that even if you come in at the top of a cycle and remain invested for at least a decade your rate of return will exceed Treasury bills and bonds. An entire industry of wealth management is based on this premise.
In 1999, the book Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market suggested the risk premium for equities was too high. There shouldn’t be any risk premium because stocks outperform bonds and have dividends that grow. The authors capitalized future earnings of the S&P 500 at 100. This is over five times what the market sells for today.
Consider, aftermath of the tech bubble, the Dow Jones Industrial Average Index dropped under 10,000 early in 2001, fulsome with volatility which often spells overvaluation, what we have currently. During 2009, the Dow based at 6,649, but by yearend 2014, breached 18,000. Now we’re at 26,000. Excepting when interest rates are minimal while the perception is they can rest there for years to come do you get an equity risk premium near zero and a market that’s buoyant.
We are still living in a new Gilded Age that will be challenged by the coronavirus if it spreads to the western world. The FRB can’t bail us out like Ben Bernanke did in the financial meltdown. Paul Volcker in 1982, ended Jimmy Hoffa’s calling the shots on wage gains of 7% to 8% per annum. General Motors and Ford gave in. Ironically, General Motors became a ward of the state in 2009 and needed big bailout money to survive and recover.
The new Gilded Age started spring of 2009. But, the problem for investors now is how deal with a market where industry leaders mainly comprise internet and e-commerce operators like Amazon, Alibaba, Alphabet, Facebook and Microsoft. We’re talking over 20% of the market valuation herein. Previous cycles, General Electric, Exxon Mobil and IBM prevailed, but then fell into desuetude on deteriorating fundamentals. Few growth stocks prevail for even a decade. Exxon is so depressed, yielding 6.5%.
The late nineties were a sham. When you adjust for tons of options issuance, outrageous write-offs and crazily optimistic actuarial assumptions on corporate pension funds, earnings just grew at their historical rate, maybe 4%, not the 8% to 9% pundits including Alan Greenspan had accepted. His valuation model was deeply flawed. Real returns are systematically lower than the earnings yield throughout financial history.
Nobody could accuse Greenspan of being wishy-washy. When he dropped the Fed Funds rate 50 basis points, January 2001, Nasdaq rallied 15% over 24 hours. The market busily discounted the coming economic recovery even while tech houses were reporting bad numbers.
Greenspan for sure was great stepping in and injecting reserves, morning after Black Monday. He read the eighties better than the nineties when he ignored fiscal drag that took place during the Clinton administration. In the Republican Congress few spending bills except for defense made it through. The Fed probably contributed to inflation by raising rates unnecessarily.
There were approximately 50 changes in the discount rate between Alan’s ascendancy in 1987 and retirement in 2006. The country wallowed in a Clinton budget surplus because of the divided Congress while the stock market was throwing off $80 billion in tax receipts in fiscal 2008.
By mid-2000 Alan was drowning in his very own pomposity. Adulation in Washington had gotten to him. Too many small changes in the Fed Funds rate. The country needed a tax cut to climb out of the tech bubble-induced recession. But Paul Volcker gets credit for the second Gilded Age which started in the summer of 1982 after he had crushed inflationary expectations. By 2000 Greenspan had become a subconscious tool of Wall Street, cutting the Fed Funds rate bimonthly.
The Board’s seriousness forever is laughable, on the level of the International Monetary Fund and economic policy pronouncers in England, Germany and Japan. They can’t punch their way out of stagnant economies and near zero interest rates. Our Fed should aggressively buy Treasuries in the marketplace, thereby injecting bank reserves into our economy.
But, they’re afraid and tentative because fiscal implications of the Trump tax cuts and spending initiatives add trillions to our Federal deficit and put us dangerously high relative to the size of our GDP and as a growing percentage of the budget’s anticipated receipts. This is no more than a few years away. Why doesn’t the timid Fed speak out?
Harder and harder for me to rationalize the market holding valuation at 18 times earnings. If the coronavirus spreads to Europe and our shores, pick your own numbers. Going back to 1985, I’d draw a trendline through a 15 price-earnings multiplier. In panics the market fades as low as 10 times earnings, sells at book value and yields 5%.
Actually, it took the S&P 500 15 years from the year 2000 to break out convincingly above a 15 multiplier. Today’s pricey market yields 2%, sells at two times book value and 18 times normalized earnings power. Who dares project a normalized setting is a shoo-in? I’m underweighted financials. Warren Buffett’s persistence herein seems a heavy cross to drag along.
Never, ever expect the FRB to do the right thing. Late 2008, still plenty of anti-stimulus dissenters at the FRB and U.S. Treasury. They shoved Lehman Brothers into bankruptcy, but saved Bear, Stearns. The market then sold down to 10 times earnings. Ben Bernanke interceded and saved us along with Bob Rubin’s sizable Treasury cash injection.
Who’s left to save us now?
Sosnoff and / or his managed accounts own: Amazon, Alibaba, Alphabet, Facebook and Microsoft.