In doing its job, the Fed turned dogs into birds
Attribution: Helen Norton (reproduced with permission).
Time value of money is a flation construct that implies there is usually a difference in buying power between a today dollar and a tomorrow dollar.
In times of inflation, tomorrow’s dollar is worth less than today. In times of deflation, the opposite holds true.
Using relative purchasing power metrics, a dollar today would in two years be worth: 94c assuming inflation of 3% pa, or $1 assuming flation of 0% pa, or $1.06 assuming deflation of 3% pa.
Given most of the world is dis-inflating, the relative purchasing power of today’s dollar might be less than tomorrow’s dollar. This implies future cash flows should be discounted to a lesser extent than in an inflationary environment.
On top of that, and with the Fed’s guarantee in place and other centrals such as the ECB also talking about debt forgiveness and bail-outs, investors can comfortably buy leveraged risky assets with the sleeping pill that if things go pear, the Fed will soak up the risk.
If the strengthening of the future dollar and the shifting of terminal (asset) risk to the Fed’s balance sheet continues (perceived or real), then the typical return expected on investments once considered risky will be perceived to be nowhere near as high as it used to be; and that would imply a lower discount rate and a significantly expanded earnings multiple.
Source: multipl.com.
The current Schiller PE ratio (using 10 year average cyclically inflation adjusted earnings) indicates the S&P500 is trading at ~76% above its mean of 16.7x.
In the absence of a massive second wave shock, there may be more to come, noting the euphoric ‘me too’ high reached in 2000 before the dot com bubble burst.
Indeed, if corporate earnings recede due to rolling lock-downs and trade wars, and if prices stay high due to monetary flows and welfare cheques, the multiple will expand further.
But for how long? Only until dogs realise their wings were made from feathers and wax and prices fall back to earth.
Mike.
NextLevelCorporate is a leading independent strategic corporate advisory firm with a multi-decade track record of delivering transformative corporate finance solutions, in and out of Australia.