Low Growth + Lower Rates = High Stocks + The Japanese Trap

I often hear the question "Given the low growth forecasts and all the economic worries, why is the US stock market valued so highly?"

I have explained previously how Stocks and Bonds can rise together in an environment where the Fed is artificially suppressing the yield curve.

"A democratic country equipped with a printing press won’t default. Austerity will fail when faced with seniors dying of poverty. However, it can and will engineer a huge monetary debasement via monetization of government debts (QE continued). US corporations will hoover up this money and cause a secular rise in profits & dividends. In real terms the Dow may not go up much, but in nominal terms this will translate into a huge rally, which began at SPX 666." - 11 AUGUST 2011

"US treasury bears will have to be very patient. There is plenty of drama to sit through before the final act - demonetization of US credit - is played out." - 30 OCTOBER 2011

"It is easy to see how a lower yield curve translates into higher stock prices. The "risk-free" yield curve is key to pricing of most financial assets. Its central role is in the discounting mechanism for future cash-flows. A lower yield curve means a higher Present Value for the future earnings and thus higher share prices. Note that the yield on stocks was in a secular decline, dropping WITH bond yields during the great bull market from the early 1980s to 2000. Another period when stock and bond markets rose together" - 23 JANUARY 2012

To demonstrate this mathematically, I have modelled 3 situations using a very simplistic model for a yield curve and a fixed rate for Earnings growth. 

To obtain a valuation for stocks in each case, I discount the next 10 years earnings to their PV and sum them up. The Initial Earnings are normalised to 100, just to illustrate the principle.

Case 1: "Normal" growth and interest rates - e.g. mid 2007

Earnings Model
Initial Earnings	100
Growth Rate	3.00%
Yield Curve Model
Level	3.00%
Steepness	0.25%
Curvature	0.50%
Year	US Yield	Earnings	Earnings PV
1	3.22%	103.00	99.78
2	3.57%	106.09	98.91
3	3.89%	109.27	97.46
4	4.20%	112.55	95.48
5	4.50%	115.93	93.03
6	4.70%	119.41	90.66
7	4.89%	122.99	88.06
8	5.07%	126.68	85.31
9	5.22%	130.48	82.51
10	5.25%	134.39	80.57
	SPX	1,180.78	911.77

Case 2: Deflation + Credit Crunch, inverted yield curve, falling earnings - e.g. late 2008

Earnings Model
Initial Earnings	100
Growth Rate	-4.00%
Yield Curve Model
Level	6.00%
Steepness	-0.50%
Curvature	-1.00%
Year	US Yield	Earnings	Earnings PV
1	5.55%	96.00	90.95
2	4.87%	92.16	83.80
3	4.23%	88.47	78.14
4	3.61%	84.93	73.71
5	3.00%	81.54	70.33
6	2.61%	78.28	67.08
7	2.23%	75.14	64.41
8	1.87%	72.14	62.21
9	1.55%	69.25	60.29
10	1.50%	66.48	57.29
	SPX	804.40	708.23

  

Case 3: Low growth, with Fed manipulated low rates - e.g. mid 2012

Earnings Model
Initial Earnings	100
Growth Rate	1.00%
Yield Curve Model
Level	0.00%
Steepness	0.15%
Curvature	0.30%
Year	US Yield	Earnings	Earnings PV
1	0.13%	101.00	100.86
2	0.34%	102.01	101.32
3	0.53%	103.03	101.40
4	0.72%	104.06	101.12
5	0.90%	105.10	100.50
6	1.02%	106.15	99.89
7	1.13%	107.21	99.09
8	1.24%	108.29	98.12
9	1.33%	109.37	97.07
10	1.35%	110.46	96.60
	SPX	1,056.68	995.98

• This simple model demonstrates that in a "normal" growth and interest rate environment (Case 1), the valuation for stocks is actually lower compared with an environment where the rate of growth is low, but interest rates are artificially suppressed (Case 3). Only in a deflationary environment with funding stresses (Case 2) do stock valuations fall significantly.

• This explains why BOTH stocks and bonds have risen over the past few years. In the process of suppressing the yield curve using QE & Twist, the Fed has driven bond prices up.

• Instead of the normal inverse relationship between stocks and bonds, the low yield curve has increased Stock prices by increasing the Present Valuation of future earnings. The Fed does not like falling Stock markets due to the "wealth effect" acting in reverse. Falling stocks will reduce consumer spending (and therefore growth) even further in a negative feedback loop

• Therefore, until the Earnings Growth Rate increases, the Fed is stuck with keeping the yield curve suppressed - any RISE in rates will now cause stocks to FALL. Also, the US government is forced to continue its huge deficits indefinitely, otherwise the present anaemic Earnings Growth Rate will turn negative due to the ongoing consumer de-leveraging, and cause Stock markets to fall.

• This Fed is forced to absorb new Treasury issuance indefinitely, until the de-leveraging process is complete and consumer purchasing power is freed up from debt-servicing and diverted back to spending

• Ultimately, absent a financial or austerity shock (which there could be plenty of) - the market will stay buoyant, as long as the Fed keeps buying and the government keeps spending. The US debt situation is destined to become the same as Japan, with large deficits as far as the eye can see, and many years of wasteful government spending projects.