US isn’t exactly an economic dictator. Most countries need to maintain their trade imbalance with the US to maintain their growth and employment. If the dollar suddenly becomes cheaper then everywhere else has to become relatively more expensive and the workers of these country will suffer. So it is always something of a race to the bottom rather than the US sticking it to everyone that the dollar is going to be strong whether they like it or not.
You would expect to see asset and commodity prices rise against all currencies in this situation but due to the demand shocks we are still seeing the opposite, so risk is toward deflation despite all the printing.
The only way I can wrap my head around current equity prices and their relationship with the real world assets underlying those instruments… is if we’re all just assuming that dollars are worth 30-40% less in six months.
Even then I feel like we’re significantly overvalued, but I’ve been massively not OK with the price of stocks since 2014 or so. I’m one of those guys who thinks the PE of the average large corporation should be ~10, with worse than average being ~8, and huge moats being 12-15. This is because I think that most huge corporations EV for still existing is ~20 years and the normal PE for smaller businesses is like 3.5-4. Obviously super young growth companies that are small with huge ceilings are a totally different game, but let’s be clear no company worth >10B dollars is one of those.
The very simple explanation is that investors allocate money based on their perception of expected return. The natural benchmark for US equities is the risk-free long-term treasury. If that treasury rate is something like 1.5% for the 30-year, then an expected equity return of 5% or so is totally normal.
You can wish for P/E ratios of 10, but that doesn’t make a whole lot of sense in a world where the risk-free rate is <2%.
The consequence of all this, of course, is that if a 5% expected return leads to a P/E ratio of 25 (e.g., E/(r-g), where g=1%), then if you buy stocks at a P/E of 25, you’re going to (in expectation) earn 5% returns going forward. That seems quite low based on historical returns. But if you choose not to buy, what are you doing with your money in the meantime? Buying long-term treasuries similarly earns you lower-than-historical returns.
I think the biggest bear case for equities crashing is probably some kind of massive deleveraging/default/velocity of money dramatically decreasing contagion that basically destroys a ton of the money that is responsible for current equity prices. It is one reason they have been so desperately driving trillion after trillion into the hands of the rich/banks/etc.
I completely agree that there is no place else to park money right now and that is the biggest reason for the absurd valuations. The only question is can the Fed/Federal Government stave off the terminal deflationary/deleveraging spiral that is certainly possible in this environment.
Oil being at $10.50 a barrel in USA #1 and negative in some areas is one small sign that deflationary pressure is the real risk in this environment. Oil is different than US stocks or even US commodities because it is really not savable through US stimulus/monetary policy. It is a global market. And seeing it basically go to zero is an indicator that the global economy is in serious trouble.
There are also bubbles in basically every income producing asset class. Commercial real estate is selling for 25-30x annual income before debt service. Even shit like railcars and airplanes have been bid into historically ridiculous valuations.
So obviously I agree with all of this. My issue with this line of thinking is that I think it massively underprices the risk you’re taking buying an equity, particularly an equity in a company without a super strong balance sheet (IE one with debt to service).
I think the typical S&P 500 company has a 0-10% chance of seeing their entire business model fall apart any given year. I think companies, like all organisms, have life cycles, and the longer in the tooth they get the more likely it is that this is their year. Look back twenty years and you’ll see that a surprising number of big blue chip stocks have failed, or at the very least seen a very significant drop in future earning potential.
I don’t think something with that kind of risk can be compared to a ‘risk-free’ (it isn’t because what’s happening now can absolutely happen and you can get stuck holding a bond with a 1.5% rate in an environment where the value of a dollar goes down by 40%) treasury bond in any way shape or form.
Given the fact that the odds I’m being offered suck pretty hard I’d rather find real world stuff to invest in that generate a significantly better risk adjusted return (which is to say the risk is significantly higher, but so is the return) and just make sure I’m not over exposed.
I say this fully understanding that most people holding 50k can’t just say ‘fuck buying stocks I’ll hire 5 salespeople for 10 weeks and see if any of them turn into freight brokers who net me 60k a year for 3-5 years, which will only work about 50% of the time (for all 5… but occasionally you’ll run like god and get 2-3 to hit)’.
Like let’s be clear I’m seeing stock prices hold up, but I’m seeing massive deflation in the price of used trucking equipment. Definitely a much better bet than a basket of stocks. For me the real question is BRK vs trucks, and we’ll see which way the stock market goes. I think if it craters buying BRK on sale and watching it rise on Warren Buffetts last bailout dance is probably more +EV, mostly because the chance of actually losing money is lower.
Well a ton of the equity in BRK is in its stock portfolio so it will likely initially decline with the value of those holdings even though it has ability to buy other assets cheaply if valuations get there.
Biggest trigger for stock price decline is still the virus. Confirmation people are getting reinfected after recovery, any delay in a likely vaccine, a country needing to return to lockdowns after opening up businesses, these type of news events would be the most likely thing to set off a decline.
Bankruptcies outside of travel, oil and gas, or retail industries could also set off a decline
There’s been a string of tanker cars sitting on a rail spar in my town. It’s been there for two weeks or so. Didn’t occur to me until now but I’ll bet it’s full of oil, probably hundreds of trains full of oil sitting in railyards across America.
So this is the standard “firms are risky and can go out of business” argument, which is true. And that’s why you require a higher return to take on that risk. But how much extra return do you require? What makes you say that risks are underpriced? Historically, that number (the equity risk premium) is anywhere from 3-6%, but that still doesn’t get you to a large firm P/E ratio of 10 when 30-year bonds are yielding <1.5%. I’m not sure how you quantify the right price of risk, but I think your example of the last 20 years experience argues against your point. Despite your “surprising number” of failed blue chip stocks, aggregate market earnings and returns have been reasonable (roughly 5-6%) despite coming off the peak of the dot-com bubble, very low inflation, and a time period including the 9/11 attacks and the global financial crisis.
If you think there’s a significant risk that the value of a dollar goes down by 40% (presumably because of rampant inflation), there’s an obvious solution - buy Inflation-Protected Treasuries. They’re currently pricing in a 10-year inflation rate of 1%.
The odds of what suck? Across the entire spectrum of asset classes, expected returns are low, that’s true. But such is life - it’s an indication that real risk-adjusted rates of return are univerally low; it’s not a sign that equities are uniquely overpriced. Everyone is looking for a better risk-adjusted return, but you don’t get a better risk-adjusted return just by taking on more risk.
Like let’s be clear I’m seeing stock prices hold up, but I’m seeing massive deflation in the price of used trucking equipment. Definitely a much better bet than a basket of stocks.
I’m not sure why you’re describing a decline in prices as deflation, but if you think used trucking equipment offers a better risk-adjusted return than stocks, then go nuts! I mean, for any asset you look at, the question is how much the asset will generate in future cash flows, how certain you are of those future cash flows, and what price you’re willing to accept for risk. If I were looking at a decine in used trucking equipment prices, it would be really important for me to determine whether the decline was due to lower expected cash flows or to higher required returns. If it’s the second, great, I’d be a happy buyer. But if it’s the first then the decline doesn’t represent any kind of bargain…
[quote]For me the real question is BRK vs trucks, and we’ll see which way the stock market goes. I think if it craters buying BRK on sale and watching it rise on Warren Buffetts last bailout dance is probably more +EV, mostly because the chance of actually losing money is lower.
[/quote]
Buffett wasn’t super active in the financial crisis, and based on a WSJ interview with Munger a few days ago, it sounds like Berkshire is doing precisely nothing right now - no companies are approaching them for capital. That’s disappointing from a BRK shareholder perspective, but the lack of demand for capital kind of means that either things aren’t that bad or that the government is doing a reasonable job of keeping companies alive. (Or that CEOs of lots of companies are completely delusional about how bad their business will be.)