“To understand is to perceive patterns.” ― Sir Isaiah Berlin (1909 – 1997)
“The great hope for a quick and sweeping transition to renewable energy is wishful thinking.” ― Vacliv Smil
Amazon has been in the news lately and not for the right reasons:
- Nike has ended its deal with Amazon to sell its shoes and clothing directly to consumers on the e-commerce website. Nike cited a lack of follow through on Amazon’s part to crack down on sales of Nike branded products by unlicensed distributors and knockoffs by third-party sellers.
- Amazon has accused the US government of having exhibited an “unmistakable bias” for the Pentagon awarding the US dollars 10 billion Jedi cloud computing contract to Microsoft after several rounds of bidding.
All does not seem right at Amazon. Probably making it one of the large cap stocks to avoid even as the US equity market continues to head higher.
On to this week’s update.
Inflation, Earnings Yields, Stock Prices and Gold
Federal Reserve Chairman Jay Powell told lawmakers at the Congressional Testimony that he saw little need to cut interest rates further after making three reductions since July. He also expressed that US inflation should progressively rise toward the Fed’s target rate of 2 per cent.
The day before Chairman Powell’s testimony, President Trump criticised the Fed for keeping rates too high and expressed envy towards nations in Europe that have interest rates below zero.
President Trump, understandably, wants higher stock prices and a booming economy as the US heads into an election year. Since stock prices are supposed to reflect the values of discounted future cash flows, a lower discount rate and / or high earnings growth expectations should translate into higher stock prices. President Trump cannot goose up earnings as easily as the Fed can cut interest rates, from his perspective, it then makes sense that he goes after the Fed and its hawkish stance, relative to that of the European Central Bank and Bank of Japan, on monetary policy.
Assuming lower policy interest rates translate into a lower discount rate, the US equity market’s earnings yield should decline (or price-to-earnings ratio increase). Barring a sharp drop in earnings, a lower earnings yield equates to higher stock prices.
The fly in the ointment is that, historically, US earnings yields have been more closely related to the rate of inflation than to nominal or real bond yields. And, high price-to-earnings ratios have had modest predictive power over future earnings growth.
The chart below is of the trailing earnings yield of US stocks and realised inflation rates.
A comparable relationship between inflation and earnings yields exists in many other markets as well.
Theoretically, since stocks are real assets, changes in the rate of inflation should not have a meaningful impact on stock prices or valuation multiples. In practice, however, the principle does not hold. Studies in behavioural finance suggest that a cognitive bias, known as the “money illusion”, explains the theoretical and practical disconnect that makes equity markets undervalued when inflation is high and overvalued when inflation is low.
The money, or price, illusion is to think of money in nominal, rather than real, terms. That is, when inflation is high (low), market participants incorrectly discount real cash flows using nominal discount rates, resulting in an undervalued (overvalued) price.
Explanations based on cognitive biases, such as the money illusion, while appealing, lack explanatory power however. That is, analysis reveals the ‘sweet spot’ for equity valuations occurs when the rate of inflation is in the range of 1 to 4 per cent. Valuation ratios compress at rates of inflation both above and below this range. Markets like neither high-levels of inflation nor deflation.
This is bad news for long-term equity investors that consider the probability of one of either deflation or high inflation occurring in the future to be higher than the level of inflation being witnessed in the US economy at present.
Relation Between Gold and the Price-to-Earnings Ratio
The above is a chart of the S&P 500 Index express in terms of gold (in US dollars per Troy Ounce) versus the index’s price-to- ratio. In simple terms, the price of gold is inversely correlated to the price-to-earnings multiple of the index.
This relation can be better visualised by using the cyclically adjusted price-to-earnings (CAPE), or Shiller price-to-earnings, ratio as the impact of the Global Financial Crisis is smoothed out.
Outside of periods when demand for high-quality, liquid collateral is at a premium, such as during a financial crisis, the price of gold is generally driven by the trend in US real yields. Rising real yields, that is rising interest rates and / or declining inflation, tend to push gold lower. While declining real yields, that is declining interest rates and / or rising inflation, tend to push gold higher.
The critical question for investors in US equity markets, or any other stock market for that matter, to ask then is: where are real yields headed?
Higher real yields translate into expanding valuation multiples implying that positive returns can be generated even with benign levels of earnings growth. While shrinking real yields are likely to spell negative returns unless earnings really surprise to the upside.
With Mr Powell signalling that the Fed is done cutting rates for now, if a drop in real yields is to manifest, it is more likely to come from a spike in inflation. With the continued reluctance of US corporations to make capital investments, the most likely candidate to lead a spike in inflation, in our opinion, is an unexpected rise in the price of oil.
Equity market multiple contraction risk can be hedged by owning gold or by investing in oil related plays such as companies operating in the energy sector. With gold having rallied to multi-year highs just recently and energy stocks trading at or near multi-year lows, our preference is for the latter.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.