The Power of Looking Ahead (And Why It’s Worth Trillions)

by JT McGee

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.

{ 17 comments… read them below or add one }

Bill August 8, 2011 at 10:16

The politicians were in washington for the balanced budget under Clinton. I remember my portfolio gaining 200% in 7 years. I also remember paying a lot of taxes.

I have not paid much in capital gains taxes lately. I would not mind paying taxes if my savings would grow faster.

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JT McGee August 8, 2011 at 15:30

I missed out on those good ol’ days of 200% in 7 years. Second only to the children of the depression, my generation would be the children of the world’s greatest recession. 😉

I’d take faster savings growth for a bigger tax bill, too. I think most would. Too bad Washington doesn’t get it.

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krantcents August 8, 2011 at 11:22

The unknown is far scarier than anything they could do. I would be happy with a few well thought out decisions. I doubt that Washington is up to the task.

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JT McGee August 8, 2011 at 15:31

Exactly. Pick something, stick with it, and let the market do its thing, right?

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Doctor Stock August 8, 2011 at 11:39

Hey… I found you on my first day on Yakezie… and I’m glad I did. Great site. I love the perspective presented… My personal concern is the general mentality seen everywhere in the first world countries… simply borrow now, spend, and someday we’ll pay it back. Unfortunately, payback is now! And the economy will continue to struggle until we quite putting money from one pocket into the other… because the other one has a hole in it!

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JT McGee August 8, 2011 at 15:33

Good to see you, Dr. Stock. I’ll have to check out your blog here in a bit, but I do want to welcome you to Yakezie. Great group, really.

The thing that concerns me the most is that liabilities only grow without action. Plus, each day we wait is one more day that people become eligible for Social Security. If we don’t make entitlements a priority before the major voting block starts getting their monthly check then we’ll never see reform.

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Doctor Stock August 8, 2011 at 15:38

So true… that is one of the challenges of an “economic democracy.”

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Squirrelers August 8, 2011 at 16:28

Great post, JT. Intelligent observations here. I hadn’t thought of PE multiples in that way, but this makes sense. Also, your points on housing prices factoring in future risks are well taken. Taking on 15 year, much less 30 year mortgage, requires the ability to be confident in making those payments. There’s much uncertainty in that these days.

On both sides of the ball, Washington has not shown the ability to effectively handle making big economic policy or embrace change decisions decisively and swiftly. To some extent, that’s a great benefit, but in a world that’s speeding up, it can be a detriment too. Our system is great, but the people we elected need to actually serve us, their constituents, rather than posture and bicker. They work for us, after all:)

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JT McGee August 8, 2011 at 19:48

Thanks Squirrelers, for both the comment and RT. Much appreciated.

Really, I just wish Congress would

1) Completely rework the tax system to remove all credits/deductions/whatever and arrive at a very simple tax code with a few brackets. This income gets this rate; the next gets this rate, etc.

2) Start getting rid of complicated regulations, even those that are revenue positive. Sure, it’s easy to say that regulation X earns the government Y dollars. But what is the opportunity cost? Is it worth the government earning $500,000 to certify a new factory/whatever if the cost is a slowdown in the building of a new $10 million business? I think not.

If there’s anything I know it’s that when you subsidize something you get more of it. Why not start removing unnecessary hangups in the system resulting from the inability to forecast? Remove all the constants in an equation (the economy) which should only have variables. Laws create constants, they create inefficiency, and we need less of them and then a guarantee that we’ll just stick with what we have.

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The Dividend Pig August 8, 2011 at 19:26

I prefer to paraphase dick cheney here – “deficits don’t matter”. And they don’t, at least for a period – if you look at any of the writing from the most intelligent economists in the world, us running a high deficit now, in the long run is moot. As long as there is inflation, and our real debt decreases, we are not insolvent.

Yes, our path is unsustainable, but keep in mind the only reason we are here today is because of the stimulus. Without it, the stock market rally of last year would never have happened, and much like we are seeing now with the ending of QE2, prices would have remained depressed.

First and foremost, America has an employment issue – and the best way to grow employment is to throw money into the system. Sure, we need to reign in entitlement programs, but we have 30 years to do that. I tend to lean right fiscally as well, but I also believe in facts and research – and all of that points to exactly the opposite of austerity.

If we were fiscally in trouble, the s&p downgrade would have decimated the bond market. But it didn’t. It decimated stocks, while bond yields dropped even lower. Treasuries are the still the world’s safe haven. If we cut off spending and institute draconian budget cuts, we are the ones who will hurt the most.

Whew…no that that’s off my chest i can breath again…I’m not sure why I leave my longest comments on your blog, but I do. Sorry

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JT McGee August 8, 2011 at 19:34

Ha, I’m glad you leave long comments. I’m glad there are people that care that much.

I agree that deficits don’t matter to an extent. However, change in debt to change in GDP is now negative. I don’t exactly point toward austerity. I don’t think austerity is the solution. Let’s grow our way out of it.

I prefer that we go back to the supply side. Increase supply by reducing burdens to growth (regulation, complicated tax codes) and you’ll lower prices (allowing for higher inflation) and improve output (and thus reduce unemployment.) It’s a win-win-win situation.

I still think we can grow our way out of it, but QE to any degree is not the end-all solution. Neither is spending money direct from government. In my view, the best way to reduce unemployment and increase output is to get rid of the barriers to entry that keep output suppressed.

It’s so simple that it’ll never happen.

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The Dividend Pig August 10, 2011 at 18:35

There’s no doubt of that – growing our way out is the only answer. I think that it’s a mistaken belief though that government spending won’t help. The closest event to this recession, our great depression, was ended by government spending.

when the government spends (as long as it does so wisely, which something like cash for clunkers was not) and gets people working, demand increases. When demand increases, companies hire, increasing demand further, and hopefully the cycle continues.

I think the idea that cutting regulations and taxes is not a cure all. Just look at the past two years – companies with record earnings and clean balance sheets yet no new jobs. Businesses learned they can do more with less, and only an increase in demand above capacity can spur hiring. A simple tax cut or removal of a regulatory burden will only increase profits, not employment.

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JT McGee August 11, 2011 at 06:00

Haha, cash for clunkers. We can certainly agree that C4C was not, in any way, a reasonable use of a federal dollars for the purpose of stimulus.

I’m cool with some stimulus spending on top of regulatory/tax code overhaul. Why not throw a little fuel on the fire after you stoke it with a stick (regulatory/tax code changes)?

The way I see it is the US Treasury can borrow inexpensively, and should make some investments in infrastructure. Infrastructure isn’t a bunch of moronic “shovel-ready” garbage that we just throw into the stimulus package. I want long-run benefits from the spending.

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cashflowmantra August 10, 2011 at 11:45

JT,
You hit the nail on the head. “It is so simple that it’ll never happen.” That’s it in a nutshell. So now I have to live with the uncertainty of no leadership and strive to protect myself and my family. It is all that I can do right now until there is some vision. Sad, but true.

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JT McGee August 10, 2011 at 12:00

Sad, but true, indeed. Good thing our governor has our state in gear. 😉

My Man Mitch, right?

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Invest It Wisely August 17, 2011 at 19:39

I agree with you: F the uncertainty. Go back to simplicity, meaning taxes, bills, and regulations that can fit on a SINGLE piece of paper, not an encyclopedia-sized volume. Encyclopedia-sized volumes are nice create-work schemes for lawyers and help out big businesses that can afford it by making business more expensive for smaller businesses that become burdened by the extra costs, but these costs are a huge drag and deadweight on the economy.

As for things like C4C, why couldn’t they have shipped those cars to Ethiopia or a place like that? Those cars would have been seen as luxury vehicles over there… 🙂

As for deficits… sure, they don’t matter, so long as someone’s willing to offset it. Sure, the US can never nominally default even if nobody wanted its bonds, but in the end you only have so many resources in the economy, with money only representing who gets what out of the pie. Paying people to destroy cars or manipulating prices to prop up the nominal value of houses or whatnot doesn’t do anything to increase this pie; in fact, it decreases it. The way out is for this supply of real resources to grow, which is what results in real growth for everyone.

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PC November 26, 2011 at 08:56

As an investor, it all comes down to this: Who do you trust to give you investment guidance you can count on and profit from? Do you trust reporters and journalists that are telling you what happened yesterday? Do you trust stock brokers that make their money when you buy stocks they recommend? Investment analysis today needs to unbiased and independent. You should only pay for the investment analysis you use and you shouldn’t buy that analysis from someone who makes money off your trades.

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