stock market price display abstract

Why Stocks are Expensive in a Low-growth World

I watched last night’s State of Origin match with a neighbour mate of mine. While we live in Melbourne, we’re both originally from New South Wales.

He’s converted a little area at the back of his place into a ‘man cave’ — a bare room with no heating, an old lounge and a TV. Perfect.

The result was obviously disappointing. NSW paid the price for some poor selections in key positions. There will be changes!

Anyway, the point of telling you this story is that, at half-time, my mate and I were discussing work. He works in logistics for a multinational consumer brands company. The directive from head office in Europe is to cut costs all over the world. The Australian operations have already seen job cuts. And there will be more.

They’re also cutting advertising expenditure, which is weird if you’re trying to grow revenues. It suggests these companies are in structural decline, or that traditional advertising is no longer generating adequate returns on investment.

My mate is also a close follower of financial markets. While not an expert, he has direct share investments in his superannuation fund so he follows things closely.

He asked me, quite incredulously, how the market could be so high and expensive in such a low-growth world. He was wary about continuing to hold stocks when they were so expensive.

This goes back to yesterday’s topic where I said the game was rigged. It’s not fair that savers are penalised for their hard work and thrift with negative real interest rates.

It’s not fair. But that’s the way it is. You have to deal with reality, not with what you think should be the case based on ‘fairness’ and notions of morality.

I told my mate the stock market looked expensive based on traditional valuation measures. But I also said there was an entirely rational reason for that.

The reason?

The alternative is even more expensive

I explained that Aussie government 10-year bond yields recently traded below 1.5%. That’s a price-to-earnings multiple of 66-times! So Aussie stocks, at around 16-times earnings, don’t look that expensive to the pension fund manager trying to generate their 7% annual return (or whatever it is).

As long as stocks can avoid profit downgrades, share prices are likely to remain at historically high levels. And therein lies the catch. Stocks justify being ‘expensive’ as long as the economy holds up and sustains company earnings growth. But if it slows to the point where widespread earnings downgrades start to kick in, then the market will sell off sharply.

Capital will flee back to the safety of the bond market, seeking safety from earnings downgrades. In that environment, a tiny guaranteed return is better than the potential loss of capital.

When I explained this, my mate realised his predicament. Damned if he does, damned if he doesn’t.

This is what idiotic central banking does. It forces risk-taking behaviour upon individuals who should not be taking such risks. And it works at both ends of the spectrum.

That is, people trying to live off their savings have to take more risks with their capital, opening up the possibility that they may sustain a permanent loss.

And those who are at the start of their wealth building phase have to risk taking on more debt than is prudent, simply because everyone else is doing it due to low interest rates, and if they don’t too, they’ll be left behind.

Of course, if you lose your job in this situation and can’t service the debt, you’re in all sorts of trouble. Not that the RBA gives a damn. They look at the risks to inflation, not humans.

At least that’s the case when they’re setting policy. When they leave Martin Place (the home of the RBA) they seem to come to their senses. For example, in today’s Financial Review, former Deputy Governor of the Reserve Bank, Stephen Greenville, writes that the inflation targeting mandate of the RBA no longer makes sense:

When the inflation-targeting framework was put in place in Australia a quarter of a century ago, inflation was sensitive to shifts in the exchange rate, wages, economic activity and sentiment. Now monetary policy operates in a different environment, with different inflation processes.

China has become low-cost manufacturer-to-the world; globalisation has widened supply sources; the digital revolution has enhanced competition; and wage-setting institutions have changed. Not least, the success of inflation targeting has anchored inflation expectations, flattening the Phillips curve which links unemployment with wages and inflation.

Inflation no longer gives a clear reading of whether the economy is operating at full capacity.

Even someone as simple as me knows this. I wrote about it in yesterday’s Rum Rebellion and Australian Tribune. The RBA is clearly too smart to see simple truths.

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The Australian Tribune Editorial

The Australian Tribune Editorial

The Australian Tribune is an unorthodox news service. Your Australian Tribune editorial team deliver the unfiltered stories that could impact your daily life — political and economic stories you’re unlikely to get anywhere else. And we’re not afraid to step on some toes to do it. We are honest, conservative and never dull. We are an independent service, meaning we don’t answer to shareholders or outside advertisers. This helps avoid conflicts of interest that inhibit mainstream sources, which keeps our voice independent. The Australian Tribune is owned and operated by Port Phillip Publishing.
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