Valuations are stuck between a rock and a hard place, with no way up

January 9, 2018

It has been a remarkable "goldilocks period" for valuations (asset prices). Interest rates (which underpin everything in finance) are historically low, and the economy is historically strong. Here's a graph demonstrating that with arguably the two most important macroeconomic variables outside of GDP:

We can see that, remarkably, both rates are near all-time lows. Outside of the current period, interest rates are lower than any time in history outside of a short stretch in the mid-2000s. Unemployment at 4.1% is also near historic lows, and well below what the Fed believes to be a sustainable rate (4.6%). 


Allowing all of this is historically low inflation, which is only lately nearing the Fed's long term target of 2%.


The implications of this for asset prices are fascinating. Consider low interest rates: fundamentally, an asset can be reduced to a stream of expected future cash flows. To get a value for it today, those cash flows are "discounted" because cash in the future is worth less than cash today. Investors do this discounting using a rate- some % amount per year that captures the relationship between time and present value of a future payment. The Fed Funds rate underpins this rate- as the Fed raises its rate, the rate investors demand increases.


When discount rates are as low as they are today, a small increase can have a dramatic impact on what assets are worth. For example, the equation to calculate a steady stream of annual payments into gratuity is 1 divided by the discount rate. So if investors require a 2% yield, 1/.02 = 50, and the value of the asset will be ~50x the value of each annual payment. If the rate required by investors increases just from 2% to 4%, the value of the asset will fall to 25x. Small changes in interest rates can wreak havoc on asset prices when interest rates start low, and the further into the future the expected cash flows are the more biting the impact.


We're now in the unique position where half a generation of investors hasn't seen a Fed funds rate above 5%. Paired with below sustainable unemployment, and we seem to be reaching a point where this goldilocks regime is stuck between a rock and a hard place.


Either the economy needs to soften or interest rates need to continue rising. That raises the very real prospect that the economy continues to do well, but asset prices fall or stagnate because rates surprise to the upside after a decade of surprising to the downside. By my estimates, a 3% increase in the Fed Funds rate over the next few years equates to a 30-40% reduction in stock market valuations, which is almost impossible to make up for with earnings growth. The same basic logic applies to every major asset class, including real estate. 


So the current goldilocks scenario could very easily be a trap, with no way up for asset prices no matter what happens to the economy. 







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