Trillions and trillions of dollars worth of debt around the world has flipped to negative real rates. Across Europe, Asia, and North America one can expect to buy bonds with negative real returns. Japan's entire yield curve has flipped negative in real terms. The concern is no longer return on capital; it's return of capital, and that's assuming receiving the promised return (no default risk).
Example of Japanese bond yields, from Bloomberg:
Take this into account when thinking through the basic finance model of capital asset pricing model (CAPM). At the most basic level, the investment in the least risky investment portfolio yields a certain "risk-free rate of return." As the right kind of risk is added to the portfolio, expected returns increase. For example (from Wikipedia):
However, at this point (April 2015) the risk-free rate of return is negative. The premium for consuming later versus consuming now is negative. One must assume a risky investment portfolio just in order to not lose principal! In simple language, if you want a very low-risk investment that does not lose money, a year's supply of toilet paper should be an asset to include in your optimized portfolio.
I once read a book by Ken Fisher in which he pointed out that when looking at indices in a stable economic environment, the Earnings-to-Price percentage is more useful conceptually than the Price-to-Earning ratio. Take the P/E ratio today, and flip it into a percentage. Conceptually we can then put stock P/E ratios or forward P/E ratios (forecasted earnings based on today's prices) right into the CAPM model. Take today's 20.87 P/E, and it becomes 4.8% earnings to price.
Today we are looking at risk-free real returns of 0% or lower. When we evaluate the earnings-to-price percentage in the S&P 500, we see a return of 4.8%. As the risk-free rate fell to zero (and QE was added on top of it) around the world, stock market indices skyrocketed. However, arriving at the destination (e.g., S&P's 4.8%), where is there to go? Some will argue that P/E omits the amazing future growth. However, YOY earnings look and are forecasted to continue negative, and that's in an environment where debt cannot be any cheaper. Low bond yields decrease borrowing costs and boost earnings. Lower bond yields also drive stock prices up as the earnings-to-price percentages fall in line to the new returns for risk. From my perspective, we have reached the top of the mountain with no place left to go.
I am not forecasting armageddon or an immediate 30% global correction, but it is difficult to create a scenario in which earnings will increase at the pace needed or see further decreases in the "earnings-to-price" percentage metric. However, if bond yields were to increase, the cascading effects through the CAPM curve would necessitate a fall in prices unless it was accompanied with increased prospects for earnings growth.
Example of Japanese bond yields, from Bloomberg:
Take this into account when thinking through the basic finance model of capital asset pricing model (CAPM). At the most basic level, the investment in the least risky investment portfolio yields a certain "risk-free rate of return." As the right kind of risk is added to the portfolio, expected returns increase. For example (from Wikipedia):
However, at this point (April 2015) the risk-free rate of return is negative. The premium for consuming later versus consuming now is negative. One must assume a risky investment portfolio just in order to not lose principal! In simple language, if you want a very low-risk investment that does not lose money, a year's supply of toilet paper should be an asset to include in your optimized portfolio.
I once read a book by Ken Fisher in which he pointed out that when looking at indices in a stable economic environment, the Earnings-to-Price percentage is more useful conceptually than the Price-to-Earning ratio. Take the P/E ratio today, and flip it into a percentage. Conceptually we can then put stock P/E ratios or forward P/E ratios (forecasted earnings based on today's prices) right into the CAPM model. Take today's 20.87 P/E, and it becomes 4.8% earnings to price.
Today we are looking at risk-free real returns of 0% or lower. When we evaluate the earnings-to-price percentage in the S&P 500, we see a return of 4.8%. As the risk-free rate fell to zero (and QE was added on top of it) around the world, stock market indices skyrocketed. However, arriving at the destination (e.g., S&P's 4.8%), where is there to go? Some will argue that P/E omits the amazing future growth. However, YOY earnings look and are forecasted to continue negative, and that's in an environment where debt cannot be any cheaper. Low bond yields decrease borrowing costs and boost earnings. Lower bond yields also drive stock prices up as the earnings-to-price percentages fall in line to the new returns for risk. From my perspective, we have reached the top of the mountain with no place left to go.
I am not forecasting armageddon or an immediate 30% global correction, but it is difficult to create a scenario in which earnings will increase at the pace needed or see further decreases in the "earnings-to-price" percentage metric. However, if bond yields were to increase, the cascading effects through the CAPM curve would necessitate a fall in prices unless it was accompanied with increased prospects for earnings growth.
No comments:
Post a Comment