As I stepped back into my everyday lifestyle from a weekend away from home, I reached for the weekend edition of the Wall Street Journal.
The headline read “A Wild Ride for Financial Markets.” Among the numbers highlighted this week was one which rang out the loudest: the S&P500 index shed $843.79 billion worth of market cap in just the past 5 days.
That’s a lot of money. Averaged over the course of 5 trading days, 168 billion dollars evaporated each day. To show the size of the losses, the United States’ economy produces less than $40 billion in GDP each day.
Ouch! Our financial markets lost four times more value each day than our economy produces in an average day.
The power of looking ahead
There is one condition which separates the developed world from the emerging markets: the ability to look into the future. On average, US-based firms carry price to earnings ratios of 15-to-1, the inverse of the 6.7% annual returns from 1900 to 2000.
Elsewhere around the world, price-to-earnings ratios are never this high. Look at Russia, where the best companies might earn a price-to-earnings ratio of 10, at the best! Why are earnings so cheap in Russia? Is it that Russian businesses are inferior to American businesses?
No. It’s the difference in risk.
Russian firms are routinely stolen by government and transferred from public markets to private ownership. Naturally, the risk of such an event, one which we cannot predict, results in lower prices for future cash flow. You wouldn’t pay $100,000 for a $100,000 house if you only had a 50% chance of owning it 2 years from now, would you? You might pay $50,000, though, for a pure stab in the dark.
Realistically, you’d prefer pay $100,000 for the 100% chance. Maybe even $110,000 as a $10,000, 10 year insurance policy.
Failing to Look Forward
Whole companies aren’t usually taken without reason in the United States. Doing business in the US is generally pretty safe. Companies earn a security premium in their valuation. And, as we all know, Wall Street buys future cash flow today when it buys companies.
Our biggest problem in the United States isn’t just one item, nor one budgetary constraint; it’s that we suffer from the developed world version of weakness: the windshield is cloudy, but the rearview mirror is infinitely clear.
Much of this problem, I suggest, comes from Washington DC. Everyone knows that big changes have to be made to balance the budget, and reign in future spending. Everyone knows that the current path is mostly unsustainable.
But no one knows how DC is going to solve these woes. So no one knows where they should put their money. And if we don’t know where to put our money, then…well, why not just hold onto it?
The same is true for businesses. If they cannot look into the future with certainty, then why would they invest in new employees, factories, and capital goods, which have a payoff date not days, weeks, or months, but years into the future?
If consumers don’t know what their tax rates might be two years from now, then why would they buy a car today if transportation is a product that pays off over 10 years? Why buy a washer or dryer, a durable good, if tomorrow is unpredictable?
If real estate values are in the red, it’s not just because real estate prices were overpriced. More correctly, real estate was priced for a future reality that hasn’t yet come. We were pricing houses on a growth trajectory, not a recessionary path. Because housing can be financed as far out as 30 years into the future, the present value of homes adjusts with each boom and bust. Who in their right mind would buy a home without the confidence to pay the bills for the next 15 years? No one.
Tying it all together
The stock markets are priced into the future. Investors look at the net present value of future cash flows, and adjust today for 10, 20 years. With century bonds, seemingly arbitrary future cash flows 100 years from today are just as important as tomorrow’s earnings.
Our deficit is partially a problem of revenues as most people would argue. But what better way to reap the benefits of increased revenues to the government than to let investors buy future cash flow at higher prices? Capital gains earn 15% or more for the US government.
Should Wall Street see some clarity on tomorrow, they’ll pay for it today.
I tend to lean right fiscally. But you have no idea how much I’m willing to give up on political purism for simplicity.
It’s time that we just pick a solution and then not screw with it. Pick a tax rate and let it be. End all short-term stimulus, because it only skews our ability to forecast. Focus on the long-run, and let everything fall into place. It will. I’m willing to bet on it.