Few investors around these days know the significance of 1989. It was the year that marked the top of the Japanese stock market.
In fact, the exact date was 12/31/1989. Rather poetic, don’t you think? Interesting story about how Japan came to economic prominence. After WWII, the US helped rebuild the country. To do that, they taught the manufacturing techniques used in the US that resulted in manufacturing excellence, like continuous quality control, just-in-time inventory, etc. The 50s and 60s saw Japan rebuild its manufacturing base literally from the ground up.
As a macro tactic, the country exported its way back to wealth. The only way to wealth is to produce more than you consume. Countries do this by running a trade surplus. The trade surplus allowed the government, its people, and corporations to accumulate wealth and foreign assets. That process accelerated in the 1970s and 80s.
A contributor to the rapidly expanding economy that was not well understood at the time was economic expansion was also fueled by massive money printing by the Japanese central bank. Since Japan was running huge trade surpluses, the Yen had a strong tendency to rise.
The central bank printed money like it was going out of style to limit its strength. Traditional Keynesian economic theory said that a rising currency is bad for exports. But exports continued to rise and along with their currency. Japanese manufacturers were relentless cost-cutters, looking to lower the cost of manufacturing at every turn. They were also relentless at quality improvement. Put these together, and Japan dominated world manufacturing. Back then, those who were around will remember how the Japanese auto manufacturers ran over their US counterparts with high-quality, more fuel-efficient vehicles.
Where did all this money go? It went into Japanese stocks, real estate, and foreign investment. Back in the late 1980s, the Imperial Palace was said to be worth more than the state of California. These two asset classes experienced bubbles of biblical proportions. Check out the chart of the NiIKKEI 225 below.
From 1960 to the peak in 1980, the NIKKEI 255 rose by a compound annual rate of 13.6%, a 46 fold increase in 30 years. It appeared that the Japanese people could do no wrong, and the politicians in the US and Europe feared the Japanese would dominate the world economy. But then reality struck. The effects of money printing, bad international investments, and a global economy restructuring brought their economic hegemony to an end.
It also popped the equity and real estate bubbles that developed during the gogo years. The NIKKEI topped out at $40,000 and went downhill for 19+ years. It appears that Japanese stocks bottomed in 2009 and have been moving higher never sense.
This bit of financial history should provide a cautionary tale for equity (and maybe real estate) investors who think that US stocks can only go up. The NIKKEI is currently trading at around 28,800. So anyone who bought in 1989 still has not broken even on their stock investment even though 31 years have passed.
This situation brings us to the nervous nature of our view on the investment prospects for US stocks over the past year. We have been wondering what would break the back of the extreme optimism in investors’ minds. At the moment, we think that catalyst will be inflation brought on by what we have been saying as the most significant policy errors by the government and federal reserve in history.
(The alternative is a collapse of the European financial system. Zero-interest rates have destroyed the banks’ profitability, and we do not see a way out. We have read a few articles that US banks quit lending to European banks because they are afraid it is just a matter of time before they tip over again. But we will leave that conversation for another day.)
The 1970s was a decade of high inflation and economic turmoil. The Dow Jones Industrial Average provided a cumulative return of 0% over that ten years. The DJIA had two sharp selloffs of 40 to 50% during the decade, making the name of the game “volatile.” People have forgotten how bad inflation is for business in that decade. When prices are rising fast, it is challenging for companies to plan because they do not know what things might cost.
The current consensus view is that inflation will be transitory. We think this is utter nonsense, extreme hope, or outright denial of economic laws. The chart below shows M2, which measures the money supply. [Roughly speaking, M2 consists of cash and equivalents like checking and savings account balances plus small-denomination time deposits (CDs less than $100,000) plus balances in retail MMFs.]
From 1960 to 2020, M2 grew at about 5% a year. This performance incidentally is roughly equal to the nominal growth rate of GDP. During this time, the average compound annual growth rate in consumer prices was 3.6%. M2 grew at a 15.8% compound annual growth rate in the last two years. If history is a guide, we should see the average price level rise by about 30% over the next few years. The only question we have is how fast that price rise will occur.
One area we currently see rising prices in is in stocks and real estate. Over the past two years, stock prices representing claims on tangible assets have been up 52.4%. According to Zillow, the median family home price has been up 29.6% over the past two years. But never fear, the government will report an inflation rate of just 5% for 2021 (gov reported 3.2% in 2020). We do not have a crystal ball, but we think the inflation rate will be higher than 5% in 2022 and for many years after that.
To understand why this is important, we will delve into valuation, specifically intrinsic valuation. Intrinsic represents the Present Value (PV, or value today) of all cash flows investors will collect over the life of an investment. Sorry, but I will have to toss a little math at you.
“Do” represents the divided collected over the past 12 months. “D1” represents the dividend expected in the upcoming year, “D2” is the dividend expected two years from now, and so on. “k” represents the rate of return one should earn on a risky investment. What they earn year by year is a different story. “g” represents the rate at which dividends grow year over year.
If we assume that dividends grow at the same rate forever, we can estimate the value of a stock (or index) with the equation D0(1+g)/(k-g).
Applying this equation to the S&P500 (or SPY) requires some work. The first item we need is last year’s dividend. This data point is easy since we can look it up. The Dividends for SPY last year totaled $5.72 per share.
Figuring out the required return (aka the discount rate) on a risky asset cash flows like a stock or ETF is the sum of the return on a risk-free investment plus some extra return for the risk of losing money.
The risk-free rate is easy to determine. It is the yield on a 1-year T-bill if you have a 1-year investment horizon. One could use the yield on a 10-year US treasury bond if you had a long-term investment horizon. We will use the current 1-year T-bill rate of 0.4%.
The rate of return delivered by the S&P500 above or below the risk-free rate moves around year-to-year. One can smooth that out by looking at rolling investment horizons. But if we look at the past 92 years, the average risk premium on stocks is 6.47%
If we put these two factors together, we see that the expected return on the S&P500 based on a historical experience is 6.87% (0.4% + 6.47%). But what about the dividend growth rate. We could not find the data going back to 1928, but the data going back to 1990 indicates the historical dividend growth rate since then is 5.62%. Now we can complete the calculation.
Value = $5.72(1 +5.62%)/(6.87% – 5.62%) = $483
Since SPY is trading at $475 a share (as of Jan 1, 2022, the date we posted this article), we can conclude that the S&P500 is fairly valued at the moment. This “fair value” is where our fear of price inflation comes in. As investors figure out that inflation is not transitory and that a 5%+ annualized inflation rate is the probable outcome to 10 years of massive money printing, we believe that the yield on T-Bills is likely to rise.
Looking back to 1982, we see the average T-Bill yield was 3.36%, and the inflation rate averaged 3.02%. So T-bills tend to yield 34 basis points more than the inflation rate. As investors come to realize that price inflation is not going away, we should see interest rates rise. What happens to the value of the S&P500 if we assume a higher T-Bill rate? This table revealed the sensitivity.
If T- Bill yields rise to the historical average of 3.36%, the expected return increases to 9.83%. If the dividend growth rate increases from 5.62% to 7% to 8%, the value will fall to somewhere between $216 and $338.
If T- Bill yields rise to the current inflation rate of 5.00%, the expected return increases to 11.47%. If the dividend growth rate increases from 5.62% to 8% or 9%, the value will fall to somewhere between $178 and $252. So if interest rates rise, stocks prices are likely to fall. The question is by how much. How much will be determined by how much higher rates slow the growth in profits and dividends.
At this stage of the game, it seems like investors are starting to look to higher T-Bill yields, but they have not come to grips with its effect on equity valuation. We do have a bit of recent experience on this issue. The fed started selling some of the assets on its balance sheet in 2018. That did not go over very well. Stock prices began to fall, and liquidity dried up in the financial system. It got so bad that the fed had to guarantee bank lending to hedge funds for a while.
The fed is slowing the purchase of assets and will stop buying assets altogether sometime around March or April 2022. Taking the buyer of the last resort out of the market is sure to cause interest rates to rise. The question is, will it cause price inflation to slow down. We doubt it. But we think the current expectation is for inflation to slow back down and T-Bill yield remains below 2%. If economic growth remains strong as rates rise, earnings and dividend growth may increase a bit, which may contain the drop in value.
In the final analysis, we expect a fight between the bulls and bears as if and when rates rise. This situation is likely to cause much more volatility and aggression than anything we have seen in a long time. At a minimum, we think investors should eliminate any margin debt they may have in their brokerage accounts.
Risk-averse investors and older folks who do not have much time to make up losses caused by a bear market might want to reduce risk further and hold some cash. Finally, if a volatile environment does indeed occur, we think the Cathy Wood, innovation, gogo, type stocks will get hit the hardest. Companies that have levered up to buy back stock may also find themselves in trouble. We think there could be a rotation to large-cap value stocks. These companies spin off a lot of cash, and they trade at PEs of 15 or less.
Now is an excellent time to meet with your financial advisor and discuss your strategy for the upcoming year. In our view, we think people should diversify and keep individual positions small. If any trade makes you check your phone constantly or causes you to stay up at night, it is probably too big.
Best of luck in 2022.
Slides used for 10MinuteStockTrader.Com Interview with Christopher Ule Feb 11
