May 25, 2009

Credit and PE Cycles

Credit availability, not leverage, underpins equity valuation. Actually it underpins a lot of economic output but for the purpose of this post I will stick to equity valuation.

Having lower yields on treasury bills affect stock valuation positively, as you discount future dividends, cash flow or earnings streams by lower discount rate, thereby increasing valuation. The opposite have negative affects on valuations; higher rates mean lower value. The concern is for equity valuation going forward is the rapid increase in treasuries yield. 

The massive debt being accumulated in the US and elsewhere is what will cause yields to rise quickly. Here is an excerpt from John Mauldin letter, which can explain why  yields will have to go up very quickly:
The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year.  US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn't do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let's be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less. It also assumes massive tax increases from carbon credits.

I am not concerned about where the money will come from, it will come, as supply creates its own demand at the right price. What price may that be, you ask? I bet you it is going to be at much higher yields. I suspect somewhere around 6%. Yields have already began to move upwards in a hurry. Look at the the 10 yr Treasury from Yahoo:

So here some observations: 
  • The yield rise is not a good sign for a sustainable PE expansion in equity. Given that cyclically adjusted PE, Data from Prof. Robert Shiller, have not dipped under single digit, as historically no sustainable bull market have began from double digit PE. Please look at the second graph.
  • Bull markets or PE expansions have been associated with low yields and the prospect of bear market in treasuries do not give me confidence in any PE expansion for the next few years. Observe the 70s era in the second graph.
  •  PE compression takes awhile. PE have been compressing since the burst of the Internet bubble in early 2000. That is 9 years only and that is not long enough period. If history holds we can be looking for another 5-10 years of range bound market prices.

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