In The Fullness Of Time

I’m a minister’s son. That does not, I trust, make me either a good or bad person. Where we start life does, however, ineluctably shape our thinking: In whom do we believe, in whom do we trust, and in through what paradigm of values do we live our lives? As a child, I was taught one such paradigm — evangelical Baptist. Others were taught other paradigms, some within the Christian ethos but, globally speaking, many more in other paradigms.

Almost all of us were, however, taught some mixture of sacred doctrine and prescribed rituals of behavior. As I look back, what Dad and I fought most about was the dividing line between the two. He saw most things as matters of sacred doctrine, railing against my generation’s mentality of “if it feels good, do it.” In contrast, I viewed much of what he preached not as sacred doctrine, but merely as issues of personal preference. I bought into “thou shalt not kill,” but never could find the scriptural basis for “thou shalt get a haircut every three weeks.”

Dad and I now like each other much more than we did back then. I think he is getting wiser every day, which he thinks is primarily because I’ve come to value his wisdom more highly every day. I think it is primarily because Dad now accepts that while true ethics should not be situational, not all situations impose true ethical questions. Or as I explained to Dad not long ago, if Mom asks if she looks good in a new dress, there is only one “right” answer – regardless of his opinion of the dress. And lo and behold, Pops agreed with me! As I said, he’s getting wiser ever day. 

Manna For P/E Multiple Expansion
  
Figure 1
Source: UBS Warburg

The Craft of Fedwatching

As much as I probably don’t want to admit it, being a minister’s son has aided my career as a professional Fedwatcher, and not just because of my putative ability to “preach” when I feel strongly about something. The job of Fedwatcher is very similar to that of the theologian: Identifying the dogmas and catechisms of the secular god of money creation, and within that paradigm of understanding, forecasting feasts and famines for particular asset classes. I say this with no sacrilegious intent whatsoever. It’s just the way it professionally is.

Ever since Pastor Volcker took over two decades ago, the Federal Reserve has preached three key doctrines:

• In the long-term, inflation is solely a monetary phenomenon. There is no “structural” Phillips Curve trade-off between inflation and unemployment. There exists a “natural” rate of unemployment, to which unemployment will “mean revert,” regardless of the level of inflation. But since higher inflation also tends to be more volatile inflation, raising risk premiums for productivity-promoting capital formation, the Fed’s primary long-term objective should be low inflation.
• In the short-run, a Phillips Curve trade-off between inflation and unemployment does indeed exist, born of “sticky” prices and even-more “sticky” wages. Thus, the Fed does have the real-time ability to manipulate real short-term interest rates. Accordingly, the Fed’s real-time objective should be to adjust nominal short-term interest rates to fine-tune aggregate demand, and thus demand for labor so as to nudge the actual unemployment rate towards its “natural” rate.
• Independent of inflation and unemployment, the Fed must act as a “lender of last resort” in the event of “systemic” financial market risk. While this function is directed at the deposit-insured banking system, it is deemed indirectly applicable to market-driven intermediation of capital, which is “back-stopped” by the deposit-insured banking system.

As these three Fed doctrines have become clearly understood and fervently believed over the last two decades, investors have quite rationally increased portfolio allocations to equities. If the Fed is committed to (1) promoting growth through low inflation in the long run, (2) curtailing business cycle volatility pre-emptively in the short-term, and (3) flooding the Street with liquidity whenever anything threatens to go seriously wrong, then stocks should sport higher P/E ratios than in the 1970s, the 1980s, and now, the 1990s!

Separating the Journey From the Destination

I certainly agree with much of the New Era doctrine, about which I’ve given more than a few pulpit-pounding sermons over the years. Where I part company with the newly-converted is not in their New Era faith, but in the difference between going to financial heaven and living there: Stocks will generate extraordinary returns during the journey to a higher “normalized” P/E world, but once the journey is over, the rationally-expected return to stocks will fall precipitously.

How so? Consider the following valuation metric for stocks:

or dividing through by Stock Earnings:

Manna would be falling risk-free interest rates, rising corporate profit growth, and declining GDP growth volatility – all three supporting a one-time increase in the P/E ratio. And indeed, that has happened over the last two decades, as vividly displayed in Figure 1. But once that one-time upward expansion to P/E ratios has fully discounted these three positive shocks, the expected “normalized” return to stocks once again becomes the risk-free interest rate plus the equity risk premium.

But shouldn’t the expected return to stocks reflect growing earnings as well, you ask? No. In a “normalized” world, the fair-value for the P/E ratio should already discount expected earnings growth. Thus, if (1) the risk-free rate has reached a new “normalized” floor, (2) earnings growth has reached a new “normalized” ceiling, and (3) business cycle volatility has reached a new “normalized” trajectory, there is no rational justification for P/Es to go higher. Indeed, it would be quite possible to plug in very reasonable numbers to “prove” that the P/E is already “too high.” I could do that, but will leave it to you, for either pleasure or pain.

My bigger-picture point is that even if the P/E is now “fair”, the expected return to stocks can now rationally be only the risk-free rate plus the equity risk premium. Put more bluntly, total returns to stocks over the last two decades are irrelevant in considering the merits of stocks for the next two decades. If the P/E is “fair,” the excess return from stocks relative to the risk-free alternative will equal the equity risk premium, and only the equity risk premium, as stylistically displayed in Figure 2.

Stocks: Better Tasting and Less Filling?
    
Figure 2
Data Source: Ibbotson and Associates

Misapplication of MPT

The proverbial average investor will disagree, of course, as will legions of efficient frontier mavens in both the pension consulting arena and the retail financial planner world. While everybody pays lip-service to the legalese that “past performance cannot guarantee future results,” the fact remains that past performance and past volatility of that performance is the sine quo non of prevailing asset allocation doctrine.

Investors are urged to construct an “efficient portfolio,” defined as that mix of asset classes that produces the highest expected return per unit of expected volatility risk. Nothing wrong with this approach, of course – it’s what Modern Portfolio Theory (MPT) is all about. But using historical realized returns and volatilities to project future results, independent of analysis of what various asset classes are discounting about the future is, as my friend and colleague John Brynjolfsson likes to say, a “misapplication” of MPT.

I would go a step further than John: At the end of a fundamentally-justified positive shock to P/E multiples, back-looking asset allocation processes, if widely used, impose systemic risk of an equity market bubble . How so? Consider the three efficient frontiers in Figure 2, displaying the annual returns of T-bills, T-Bonds and the S&P 500 for three ten-year periods: 1981-1990, 1986-1995 and 1990-1999. As you can observe, the annualized return to stocks increased over the successive periods, while the volatility of returns declined!

Not surprisingly, investors have ramped their allocation to stocks, as they have become both “better tasting and less filling.” Asset allocation processes based on realized returns and volatilities, rather than expected returns, imply that at the end of a fundamentally-justified epic of P/E multiple expansion, investors will actually be increasing their allocation to stocks! To wit, it is a dynamic destined to produce a bubble.

Heaven Is The Stairway
    
Figure 3

Where's the Fed

If such collective investor foolishness threatened pain only for the foolish, it would have little relevance for the Fed. After all, capitalism is not just about making money, but losing money. The negative effect of asset bubbles is not, however, limited to the foolish. They impinge directly on all three of the Fed’s key doctrines. While inflating, bubbles promote excessive capital formation, consumption and cyclical inflation risk; and when deflating, bubbles promote systemic risk to both the banking system and market-driven capital intermediation. These bubble “externalities” provide a prima facie case for the Fed to act pre-emptively to prevent them.

But the Fed disagrees, of course. Fed officials reserve the doctrine of pre-emption for cyclical Phillips Curve-driven inflation risks: When employers, each acting rationally – and putting their profits at risk, to boot! – bid-up wages to attract “surplus” labor that ostensibly does not exist, the Fed feels fully justified in hiking interest rates to thwart capitalists’ animal-spirited hiring instincts.

With respect to stocks, however, the Fed defers to the collective wisdom of investors, even when it is demonstrably clear that they are being driven by irrational, backward-looking analytical processes . Beyond that, the Fed volunteers that if it turns out that equity investors are indeed committing sins of irrational exuberance, the central bank will absolve those sins with price-supporting liquidity provisions.

In the Fullness of Time
To me, the Fed’s duplicity in the exercise of the doctrine of pre-emption carries grave risk for the longevity of the current expansion. I envision an end game of: (1) Irrationally exuberant stocks stimulating both aggregate demand and labor demand, which (2) the Fed tries to check with short rate hikes, but to little avail as long as irrational exuberance is un-checked, until (3) short rates reach a sufficiently high level to “crash” stocks, which (4) torpedoes both investment and customer spending, ushering in a reversal to Fed easing.

As I stressed last month, I don’t think this outcome is what should happen. But I increasingly think it is what will happen. For PIMCO, this scenario implies a coming moment of epiphany, when we will want to lengthen durations dramatically. I’d like to be able to say at what rate and on what date that will happen. I can’t, however, because we simply don’t know. What I can say is that we recognize that you pay PIMCO to “know it when we see it.” We plan to earn our pay.