Image Source: Martin Thomas
A previous version of this article appeared on our website April 15, 2016, “The Bubble Is Still Inflating.”
No – things are not getting better. The discount rate is shrinking – and that means rising equity values.
The laws of finance continue to be bent. NIRP (negative interest rate policy) has changed everything. The world is upside down, and it seems as though every week, we hear of another country or yet another long-er duration bond that has breached below the 0% threshold, “Japan’s 20-Year Government Bond Yield Goes Negative for First Time (July 2016).” The 10-year Treasury yield hit all-time lows just last week. We wrote extensively on the NIRP topic in the February 1, 2016 piece, “Dividend Growth ‘Bubble’ To Continue But For How Long?,” and from the looks of it, the concept of NIRP will continue to drive the stock-market bubble even bigger. The SPDR S&P 500 ETF (SPY), a proxy for the S&P 500, touched all-time highs during the intra-day session July 11.
Remember when we added the put options to the newsletter portfolios in advance of Brexit, “Soros, Icahn, Nelson Hedge for Market Fall (May 2016).” It seemed as though we had been talking about an impending collapse of the market and the makings of a bubble at the very same time. How could this be? These two things are opposites. We must have been confused or something, right? Many readers probably thought we were talking out of both sides of our mouth. But fast forward to today — Brexit caused a collapse in much of the S&P 500 in the past few weeks (we closed out the option positions in the newsletter portfolios), and now the index has come roaring back to set new all-time highs July 11. Maybe not then, but perhaps now readers can understand the very difficult dynamics we were hoping to try to explain at the time. Though Brexit and the health of the UK (EWU) property market remain key risks, the S&P 500 at new highs means very little overhead resistance, and with DRIP plans and corporate buybacks providing buying power—it’s very easy to make the case that the bubble will really start to inflate.
But how? To explain, we need to cover a bit of financial theory.
Though a rather obscure article in the Journal, in April 2016, there was a peculiar story about how a Danish couple was paid interest on their mortgage, “Negative Rates Around the World: How One Danish Couple Gets Paid Interest on Their Mortgage.” You read that correctly: the couple was paid interest on their mortgage, instead of paying interest. Denmark is not the only place that is pursuing NIRP either. Switzerland, Sweden, the European Central Bank and the aforementioned Bank of Japan are all using subzero rates in an effort to drive expansion. The story of the Danish couple in that April 2016 was overlooked by some, and probably dismissed by others, but the implications are far-reaching when it comes to the laws of finance, in our view. Negative interest rates seem to bend everything we know about the financial discipline, and in some ways, break its core tenets. We’re in unchartered territory. Central banks around the world are playing with fire, and they know it.
But why should you care? Well, said more directly, the most important consideration in finance is starting to break down: the time value of money, or the idea that a dollar today is worth more than a dollar tomorrow (as the dollar today can be invested at a positive interest rate to be worth more in the future). Why is this concept so important? For one, where future free cash flows within the valuation framework are worth less as they are discounted back to today, a negative discount rate means something entirely different. Certainly the cost of equity would mean discount rates stay positive even under NIRP thanks to non-zero equity risk premiums, but an asymptotic situation is likely to unfold as all-in discount rates on future free cash flows approach zero themselves. The result as the discount mechanism gets ever smaller: exponentially rising equity prices. We think this is starting to happen right now.
This phenomenon is probably most apparent in the least risky areas of the equity markets, ones known for having the lowest costs of capital–you guessed it, the dividend-paying consumer staples (XLP) arena. Some of the most tried-and-true business models are trading as though they are aggressive growth companies, revealing multiples of 20-30 times on trailing earnings more than 18 months in the future. Even stranger, most of these consumer-staple giants also hold net debt positions on the balance sheet, further illustrating the magnitude of enterprise “market cap” that a lower discount rate is generating on these steady-eddy free cash flow generators. One must deduct the firm’s net debt position from enterprise value to arrive at equity value.
Here’s what we’re trying to say: if 20-30 times fiscal 2017 earnings is somehow reasonable today in light of existing conditions, why not 30 or 40 times fiscal 2018/2019 earnings eventually? This prognostication may sound like good news as it means higher stock prices, and maybe it’s actually great news for many, but in the event the market continues to move fervently higher, readers should understand that the advance, in our view, is being driven more by ever-falling assumed discount rates within equity valuation frameworks (buttressed by buying from dividend growth investors) than anything else. This “new,” inflating bubble is so fascinating because it is associated with some of the strongest business models that have some of the most well-recognized household brand names. This suggests to us that share prices on these equities could inflate considerably without much pushback from holders. After all, who is going to sell the Coke’s, Kimberly-Clark’s and Johnson & Johnson’s of the world in droves? Not likely to happen.
It’s starting to look like we have all the makings of an inflating bubble… until, of course, Brexit rears its ugly head again.
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