Today's Market Observation  11.17.2009  Mon  Tue  Wed  Thu  Fri  Eckert Archive

Stimulus Junkies?

Part 1

by Richard A. Eckert, cfa | november 17, 2009

Risk asset valuations soar while the economy remains chained to that small nook between a rock and a hard place

The equity markets have continued their furious rally this month, with all of the major indices up 7.0% or more since the end of October. Most of these gains were recorded in the nine trading days since the end of the last Federal Open Market Committee (FOMC) meeting, when the FOMC communicated its intent to keep interest rates low for an extended period of time. Not only did the FOMC’s statement contain the clause “…likely to warrant exceptionally low levels of the federal funds rate for an extended period” but the FOMC also reiterated its commitment to support the housing markets by purchasing $1.25 trillion of agency MBS and $175 billion of agency debt (as an aside, it is my understanding that the Fed now accounts for almost all purchases of new issues of Fannie and Freddie MBS). Reinforcing the equity markets’ confidence that interest rates would stay at extraordinarily low levels (indeed, we have to go back to the early years of the Eisenhower administration to find Fed Funds rates below 1.00 percent) indefinitely were reinforced by comments made by the presidents of the Federal Reserve district banks in Dallas, San Francisco and Atlanta.

The Fed’s commitment to providing liquidity to the financial system—as well as the broader economy—in the wake of the withdrawal of such liquidity by the global capital markets has truly been unprecedented. Not only has the Fed pushed short-term interest rates to near 0% and monetized both government and agency debt, but it has also established a veritable alphabet soup of liquidity facilities—TALF, TAF, AMLF, CPFF, MMIFF, PDCF, TSLF, TGLP—and begun lending directly to broker-dealers. The response of the federal government to the financial crisis and the deep recession it spawned has been no less unprecedented. Shortly after creating the $700 billion Troubled Asset Relief Program (TARP) with the enactment of the Emergency Economic Stabilization Act of 2008, Congress passed the American Recovery and Reinvestment Act (ARRA) of 2009 containing a $787 billion economic stimulus package. And two days after the Fed announced that it would maintain the Fed Funds rate at 0 – 0.25% this month, Congress enacted and President Obama signed into law the Worker, Homeownership and Business Assistance Act of 2009 extending and expanding eligibility for several of the programs launched by ARRA.

The enthusiastic response of equity investors to the recent actions—or renewal of commitments—by the Federal Reserve and federal government gave me pause. I wondered whether any of those investors stopped to reflect on the discordance between these actions and the reassuring statements made by public officials in recent months. I have reproduced some of those statements below:

“The force of the global recession is receding. For the first time in several quarters, the IMF and a range of private analysts are starting to revise up their forecasts for growth in the second half of this year and next. Global trade is just starting to expand again.” (Tim Geithner, July 14)

“…activity appears to be leveling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good.” (Ben Bernanke, Aug. 21)

“From a technical perspective, the recession is very likely over at this point.” (Ben Bernanke, Sep. 15)

“…forecasters agree that ‘at this point we are in a recovery’” (Ben Bernanke, Sep. 15)
“It worked.” (Bullet from a draft communiqué from Group of 20, Sep. 25)

However, the necessity of continuing to apply massive and unprecedented stimulus implied by the statements/actions of the Federal Reserve and federal government the week of November 1st—effectively, of “keeping the pedal to the metal”—seems to belie these remarks. Both policymakers and lawmakers appear to be reluctant to remove any of the stimuli thus far provided. If a nascent recovery has truly taken hold and the economy is expanding once again, there would be at least some token concern about inflation. That the Fed is willing to balloon its balance to well over $2 trillion from several hundred billion at the onset of the crisis and the federal government is willing to run trillion, trillion-and-a-half dollar deficits without fear of inflation and the higher interest rates that come with it suggest a very different U.S. economy than the one contemplated in the comments above as well as those of other public officials. 

Exhibit I 

If that is the case, corporate earnings and cash flows may fall far short of those currently discounted in equity valuations. Indeed, those valuations no longer seem anchored by prospective cash flows—or even returns—corporate or economic fundamentals (see IPO Nos – Part 1, 10/15/2009). To be fair to equity investors, low rates have been kind to equity returns (see Exhibit I above). Lower interest rates increase the net present value of expected cash flows and can help improve those cash flows if businesses can borrow inexpensively and consumers can buy more of their products. Lower interest rates also reduce hurdle rates, or required rates of return, because not only is the risk-free rate lower, but expectations of low rates are typically associated with smaller risk premiums. Finally, low rates increase the liquidity provided to the equity markets, by, for all intents and purposes, penalizing the holding of cash and practically forcing savers and investors into riskier asset classes. Which would also explain the sharp increases in home values (ironically, until 2 or 3 years ago, investments in housing were not perceived as risky—to most individuals, they represented a certain return that was far greater than one could earn on cash savings).

Exhibit II

It should be noted that the investors referenced in the last sentence of the preceding paragraph were not the homeowners themselves—although I am certain that they, too, viewed their homes as a much better, and even surer, investment than cash—but the global fixed-income community, which lapped up securities backed by mortgages on those homes with such alacrity that home borrowing rates remained low long after the Fed began removing “policy accommodation in 2004. Indeed, I have always maintained that borrowers are the last people Alan Greenspan had in mind when aggressively cutting rates over his 17 years at the helm of the Fed. Instead of easing the burdens of debt service, the aim of bringing interest rates to levels not seen since the 1950s was to compel yield-starved bond investors the world over to look at credits and collateral types they wouldn’t have touched in an earlier era. 

Although the surfeit of liquidity provided by those investors did have the effect—at least initially—of making credit more affordable for consumers and businesses, affordability was not the goal. Ultimately—and paradoxically—low rates and increasingly easier terms, because they encouraged homebuyers to pay and borrow too much, made homeownership unaffordable. Indeed, credit itself became unaffordable as debt service on oversized borrowings consumed a growing share of borrowers’ take-home pay or business receipts. Too many borrowers discovered too late in the game that it is not the interest rate or other terms of a loan that make determine whether or not it is affordable—it is the size of the loan and the number of other loans one has outstanding. That is not opinion; just simple arithmetic. If one continually spends more than one makes—or pays way too much for a property—those purchases are unaffordable, no matter what the interest rate is on the loans used to finance them.

Which brings me back to my original observation about the equity markets. The sharp increases in equity valuations this year—just like in the previous run-ups captured on Exhibit I—seem to be driven by excess liquidity, not company, industry or economic fundamentals (this observation was documented copiously in IPO Nos). While I can understand the need to invest one’s financial resources—as well as the penalty for holding cash in an era when a 12-mo. T-bill trades at a yield of less than 30 bp—I have never been comfortable with the concept of spending money or paying too much for an item just because “I have cash burning a hole in my pocket”. Just because I have a large amount of spare cash or other liquid resources or I can borrow a large amount of money at low cost does not mean I should spend $100,000 on a used Honda Accord. Or any other used vehicle falling under the rubric of basic transportation. Especially when the only basis of my decision is the belief that someone else will pay me even more for that vehicle when it comes time to sell.

I would also be cautious about chasing risk assets at current valuations when no one at the Fed, the Treasury Department, the Obama administration or Capitol Hill seems willing to remove the smallest dollop of stimulus. I believe the overwhelming margins by which the Worker, Homeownership and Business Assistance Act passed the House and Senate—403-12 and 98-0, respectively—a month before the first time homebuyer tax credit expired, the speed with which President Obama signed it into law, and the apparently concerted effort by the FOMC and district bank presidents to assure the markets interest rates will remain at historic lows for much of the foreseeable future reveal a deep concern that the economy is still on life support and that it will may need to remain there indefinitely. The sentiment I detect is that if the Fed or the Treasury or elected officials pull back the throttle on any of the extraordinary and unprecedented measures taken in the last year-and-a-half, it will send the economy careening back into the throes of a deep recession or worse. A large part of the reason for that—and one discussed at length below—is that the economy appears to be addicted to stimulus and reported growth in output is elusive without it.

The trouble with continued application of massive stimulus, though, is that the resulting deficits—and mushrooming size of the Fed balance sheet—will eventually re-awaken the inflation “monster”. Or at least the bond market’s expectations of its imminent arrival. It must also be remembered that, notwithstanding the overwhelming confidence apparently expressed of the Fed by the equity markets, the only rate the Fed truly controls is the Fed Funds rate. The global bond markets and foreign central banks control—or exert the most amount of influence—on rates at every other maturity on the yield curve, as well as the rates benchmarked to them. 

Like mortgage coupons. We had a preview of a potential showdown in the bond markets last summer when then Treasury Secretary Henry Paulson tried to whip up support of GSE debt—even after Congress provided an explicit guarantee of Fannie’s and Freddie’s bond issuances. When he learned of the cost of support of new GSE debt in the absence of government control of the GSEs, he was forced to seize both Fannie Mae and Freddie Mac. My sources tell me the Mexican and Japanese central banks were demanding rates in the low teens if they were to continue to buy agency debt. Current Treasury Secretary Geithner—or his successors—may one day find same kinds of demands made of new Treasury issuances.

One last observation in this regard. A large part of the $52.9 trillion in debt outstanding in the U.S.¹ is held overseas and in countries whose long-term strategic intentions vis-à-vis the United States is unclear at best. Historically, these countries have demonstrated a willingness to subordinate economic interests to geopolitical interests. They have also demonstrated a willingness and ability to endure the pain attendant on such sacrifices. Such pain would represent a nuisance in comparison to the damage inflicted upon the U.S. if these countries were to abandon support of the dollar and dollar-denominated assets. And, at least to this observer, the U.S. has demonstrated it can tolerate nothing but the prospect of rising standards of living.

Theoretically, equity valuations should approximate the net present value of cash flows associated with an investment in the stocks of individual companies. Since dividends appear to be an endangered species, we assume that all earnings are retained and reflected in book value and that equities—or the companies they represent—can be sold for cash at some constant multiple of book. Therefore, their value at any point in time is a function of book value and prospective increases to book value—i.e., earnings (ignoring for purposes of this discussion, SFAS 115 and SFAS 133 and other non-earnings related changes to book value). So a stock’s value at any point in time is: Net Present Value (NPV) of Book Value (BV) and changes to BV discounted back to the present at rate equal to the risk-free rate () plus a risk premium unique () to that stock. 

Or P = x *  

where n = the number of holding periods and x = the multiple of book at which it can sell.

So, if I am correct of my assessment of the sentiment of Fed policymakers and elected officials—and their appointees—the  projected in equity valuations are probably way too optimistic. And if I am wrong and a sustainable recovery has taken hold, then  is way too low—both components would likely increase if the bond markets fear inflation or begin to develop misgivings about the United States government’s ability to service current and future debt obligations (recall that there are $10s of trillions of unfunded Social Security and Medicare obligations to contend with as baby boomers retire over the next decade and a half). Even if I am right and the economy continues to languish, there will probably come a point when the bond markets revolt. Thus, either the cash flows expected of equity investments or the discount rates applied to them—or both—that appear to be embedded in current equity valuations are overly sanguine in this author’s estimation. The same can probably be said of high yield bonds and other risk assets that have come roaring back with a vengeances since March of this year. Definitely not the time to be chasing them.

Please note Part 2 of 'Stimulus Junkies?' will post next Tuesday.

¹ Federal Reserve.  Flow of Funds Accounts of the United States, September 17, 2009.

Rich Eckert

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Richard A. Eckert, CFA | (415) 674-4996 | San Francisco, CA
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