We live in a world where a teenager can discount future cash flows with the aid of a financial calculator. A little screen tells him the price/value of a financial instrument to as many decimal places as takes his fancy. This great leap forward for mankind has, however, not made the valuation of financial instruments materially easier. Indeed, the increase in the speed and ease with which man can extrapolate may have made valuing financial instruments considerably more difficult. Small tweaks in inputs have always had major impacts on present values but perhaps those tweaks were made less frequently when they were tortuous, boring, time consuming and hence expensive. Indeed, it is now possible to dispense entirely with the human element and the collapse in the cost of computing power means that intra-second, present value calculations are both possible and cheap. The rapid oscillation in price/value resulting from the interminable tweaking of our binary buddies is neither much of a spectator sport nor a game suitable for adults. Adults are interested in inputs, while machines and teenagers still marvel at the purity of the equation and the speed at which it can be solved. So what does the history of inputs to net present value calculations tell adults about current equity prices? It tells us that current equity prices/valuations are likely to produce poor long-term returns.
A simple discounting model tells us that the net present value of financial instruments rises when the discount rate falls, the growth rate of the cash flow rises or the discounting period is extended. The owners of financial assets have much to celebrate if these three amigos appear simultaneously. History shows that high valuations for equities in particular occur when just such a posse of positives rides into town. More importantly, history also shows the impossibility of such a combination having the permanency which contemporaries assume and which is thus capitalised by financial markets. Ultimately, understanding the dynamics of how such seemingly permanently bullish inputs inevitably pass is much more important for investors than celebrating their arrival. We all know that an elephant can stand on its head but the important information for those standing in close vicinity to the inverted pachyderm, is just how long can it stand on its head. Financial history has much to say on how long a low discount rate, a high growth rate of corporate cash flows and a long discounting period can co-exist. These variables can co-exist long enough for the trader to make profits and long enough for the investor to lock in poor long-term returns. So why do investors come to believe the impossible can this time be possible, and why do they stop believing?
Faith that the three amigos have come to stay usually stems from a major technological breakthrough. Investors are a sucker for the transformative power of structural change usually in the form of technology. Whether transfixed by the sight of ships sailing through the countryside (canals), iron horses rumbling across the plain (railroads), messages pulsing through wires (the telegraph), signals beaming through the air (radio), petroleum forming into household objects (petrochemicals), machines that think (computers) or phones that know where you are when you don’t (smart phones) the human mind is easily distracted by its own ingenuity.
While most technological breakthroughs are disinflationary, some are more disinflationary than others. A disinflation will very likely bring a lower discount rate, and lower interest rates also reduce interest payments and boost corporate cash flows. That same technological breakthrough can simultaneously be seen as positive for corporate cash flows if it boosts productivity. Of course, any such improvement in cash flows increases the likelihood that corporations will continue to be able to finance their liabilities and thus discounting periods may also extend. History is clear that such a confident combination of these key inputs is transient, but professional investors’ job prospects are not well served by heeding the lessons of history. So why have the inputs of a low discount rate, high cash flow growth rates and long discounting periods been transient in the past despite major technological innovations? What does that historic transience tell us about how and when faith in the current bullish combination will ebb with negative implications for prices and valuations?
This distraction of structural change driven by a new technology is fatal for investors as they simply forget that they are in the business of pricing, and price is ultimately set by just two things – supply and demand. A technological breakthrough shifts both supply and demand often in unpredictable ways; however, the mechanism of price assures that supply and demand adjust so that the three amigos of a low discount rate, a high cash flow growth rate and long discounting period are disbanded. History tells us that we should expect such disbandment when the cyclically adjusted PE for equities nears 25x. Simply put, from 1881 to 2014, despite massive structural change mainly driven by technological breakthrough, US equity valuations have only rarely exceeded a CAPE of 25x. Equity market valuations are telling us in advance that the ability of that structural change to deliver low inflation, low interest rates and high growth rates is about to come to an end. This has happened either because the growth rate was too high, resulting in inflation and higher discount rates, or because the growth rate declined taking corporate cash flows with it. In extreme circumstances cash flow declines threatened corporate solvency and discounting periods also declined markedly. In short the laws of supply and demand have always ensured that the three amigos are disbanded by either the powers of rising inflation or the powers of deflation.
When the CAPE has been at 25x times there has been no room for disappointment in any of the three key discounting variables and thus, rising inflation or outright deflation have had major impacts on valuations. To believe that this time is different is to believe that something has happened to prevent the supply/demand adjustment, which has previously made price stability in a time of high growth in corporate cash flows impossible. As at previous peaks for the CAPE in 1901, 1929, 1968 and 2000 many investors do indeed believe that this time somehow supply and demand will not adjust to shatter the combination of low discount rate, high growth rate and long discounting period. This faith is probably based upon the fact that inflation appears to have fallen to a new low trading range since 1995 and that the growth of corporate profits has outstripped GDP growth pushing corporate profits to an all time high relative to GDP. If inflation can stay low, without becoming deflation, and corporate profits can continue to rise as a percentage of GDP, then there is no reason to believe that equity prices/valuations need ever decline.
While such a permanent combination may be possible it is also highly unlikely. The historical record suggests that the actions of central bankers are at least as likely to destroy such seeming permanency as add to it. Traders can now play the game of assessing what gains can be made before the adjustment of supply and demand drives the inflationary or deflationary outcome which will reduce the price/valuation of equities. Investors need only note the inevitability of such adjustment and thus seek to avoid equities currently trading at valuations which guarantee poor long-term returns. With the CAPE at 26x the elephant remains on its head. In my opinion, this is a good time for investors to be watching from a safe distance.