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November
03
2017
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A Falling Rate of Discount and the Consumption of Capital
Warren Buffet famously proposed the analogy of a machine that produces one dollar per year in perpetuity. He asks how much would you pay for this machine? Clearly it is worth something more than $1.00. And it’s equally clear that it’s not worth $1,000. The value is somewhere in between. But where? We are not sure why Warren Buffett invoked a money printing machine of all things – another interesting way of looking at the concept is by e.g. considering land. Why does land have a finite value? After all, a piece of land that can be used to grow wheat can conceivably do so in perpetuity (even if it is merely valued as standing room, such as a plot of land on 5th Avenue in NYC, it can render that service forever. The only important attribute is that the land in question be capable of generating rents, or is at least expected to become capable of doing so in the future). Why then isn’t it worth an infinite amount? Land values are appraised the same way the values of other factors of production are appraised, namely (to paraphrase Mises) according to the services they will render at various future time periods, with time preference taken into account (if society-wide time preference is high, the natural interest rate will be high as well and land values will be affected negatively; conversely, land values will tend to increase amid declining time preference and falling interest rates). By applying a discount to a series of consecutive future time periods, one will arrive at a sequence of values converging to zero, hence the price of land is finite (sub-marginal land that cannot conceivably yield any rents will have no value at all, or at best a speculative value). This is just considering the basic ceteris paribus (or equilibrium) framework, as in the ever-changing real economy numerous other factors will also influence the appraisal of land values; still, it is fair to say that the quality of the land concerned (how much output it is expected to produce per input of labor and capital) and time preference (which determines the height of the interest rate used in the discounting procedure) are the most important factors (and it is important to recognize that they are distinct factors, completely independent of each other. Originary interest is not a function of productivity). Other factors can of course overwhelm these basic considerations – these concern mainly various types of government intervention in the economy (such taxes levied directly on land or on land rents, the security of property rights, etc.), or other developments that impact expectations (for instance, if a major volcano outbreak is expected to be imminent, the value of land in the vicinity will probably decline quite a bit). As Keith explains below, time preference is a fundamental pillar of all human action. We are mortal and in our perception of time, there is always a “sooner” and a “later”. Therefore time preference will always exist and be positive. It cannot be any other way, as all provisioning for the future would otherwise cease. Thinking of time preference declining to zero or becoming negative is akin to attempting division by zero, i.e., it simply makes no sense whatsoever. If it actually were to happen, we would consume all existing capital and slowly die of hunger thereafter. [PT] This leads to the concept of discount (which we mentioned in Falling Productivity of Debt two weeks ago). A dollar to be paid next year is worth less than a dollar in the hand today. One reason is that we are mortal beings. In order to be alive next year, we must remain alive every single day between now and then. There are natural reasons for time preference — the desire to have a good today, and not postpone it. We are also not omniscient. Something may come up, such as an illness, which forces us to consume what we did not plan to consume. Another reason is, of course, risk. Unlike the magic machine in our example, a business enterprise may cease to make money for any number reasons including a new competitor or changing customer preferences. For many reasons, a dollar to be paid next year is not worth a dollar today. A dollar to be paid in ten years is worth even less. Future payments must be discounted. The discount is related to the interest rate, and it shares many of the same causes. A Razor-Thin Margin of Safety It can be quoted as a yield, if you look at earnings divided by share price. We aren’t going to go through the formula to discount future earnings into perpetuity here. However, the math works out. The current P/E ratio of S&P 500 component stocks is 25.74.
S&P 500 Index fundamentals over time: earnings, trailing price-earnings ratio and nominal dividend yield (note: the trailing P/E ratio calculated as of October 31 is slightly lower at 24.73, presumably because additional earnings results have trickled in by now). [PT] – click to enlarge. This is the same as saying the E/P ratio is 3.89%. If you discount a dollar of earnings every year into perpetuity, at 3.89%, you get 25.74. So we use discount rate and earnings yield equivalently, depending on context and the point we want to make. The higher the price of the share, the lower the yield. With each halving of discount rate and hence earnings yield, the share price doubles. A nifty trick to create free money, eh? Just somehow lower rates and yields across the economy… It should not be surprising that discount has been falling along with the interest rate. Let’s look at earnings yield again (ignoring dividend yield which is under the control of corporations, who have broad discretion to set the dividend, hence it is not as clear a signal).
SPX earnings yield vs. the 10-year treasury yield – these have tracked each other quite closely since 1980. We should point out though that this has not always been the case and that investors are making a huge mistake if they rely on the so-called “Fed model”, which has only worked over a small slice of total market history. We refer you to a recent missive by John Hussman for details on this particular point. From an empirical perspective most people are presumably aware of the fact that the Fed model has failed to work in Japan for nearly three consecutive decades. [PT] – click to enlarge. This chart is showing three things. First and most obvious, the earnings yield on stocks falls with the interest rate (as does marginal productivity of debt as we showed last week). And it makes sense, the more the Fed pushes down interest, the more attractive equities become. At least until their yields are pulled down closer to Treasury yields. Second, yield purchasing power is falling. This is not how many groceries you could buy if you liquidate your stocks (as the mainstream view would have you think). It is how many groceries you can buy with the earnings of the businesses you own. Stocks are partial ownership of businesses, and as a shareholder you a portion of the earnings is yours. As yield purchasing power falls, it takes more and more capital to generate enough income to buy food. At the current level of 3.89%, if you need $50,000 a year to live, you need about $1.3 million worth of S&P shares. And it’s actually worse than that. Corporations do not pay 100% of their profits to shareholders. At present, they pay out a bit under half of their profits. To live on the dividends, you would need about $2.7 million worth of shares. But as we noted above, equities harbor a significant risk that the business will become less profitable. Debt must be paid. Dividends are optional. Third, and you probably saw this coming, the discount rate is falling. The market price of that dollar of earnings way out in the future, years away, is rising. It is saying that a dollar to be earned by the corporation in a decade is worth over 67 cents today. And a dividend to be paid out in a decade is worth 83 cents. I hardly think we would be alarmists or perma-bears by saying that at such a low discount, investors have a razor thin margin of safety. This is without getting into the rising debt level to maintain even this profit. Nor the problem of companies borrowing to pay dividends. Bureaucrats Toying with Powerful Forces We want to underscore one final point here. When the Fed pushes down interest rates, it manipulates discount and hence measurement of both time and risk. It is toying with powerful forces, which should not be toyed with. All the king’s horses and all the king’s men know little about the damage they wreak. They focus only on the rate at which consumer prices are rising, or perhaps GDP. Meanwhile, investors are forced to pretend that a bird 10 bushes away is worth almost as much as a bird in the hand. We can only shake our heads again, and refer to the impotence of governments to repeal natural law with legislative law. We can only point to the example of King Canute. The tide did not roll back on his command, nor do time preference and discount bend to the will of King Fed.
A depiction of King Canute and his entourage in a vain attempt to stem the tides. There was a time when economists saw it as their duty to tell governments that economic laws could not be magically suspended by government fiat. Governments did not like that one bit, so they decided to “buy” the science of economics, which consequently has been in the service of the State for quite some time now. Among the results of this momentous decision are the biggest debtberg in human history and a steady decline in economic output growth. Eventually, something will break and we suspect it will make the 2008 crisis look like a walk in the park. [PT] We love to hate the expression “it’s not a problem until it’s a problem,” but it seems so apropos to the unsustainable trends of falling discount, rising corporate debt, and the falling marginal productivity of debt. The above, by the way, describes a process of capital consumption. Of eating the seed corn (two processes, if you count corporate borrowing to pay dividends). With each new speculator buying shares at ever-higher prices, there is a transfer of wealth from the buyer to the seller. The seller receives it as income, and spends some of it. The sellers are consuming some of the buyers’ wealth. These buyers fork over their wealth in the expectation that new buyers will come along soon, and give them even more wealth. This is also known as the wealth effect, without any apparent irony. The people it harms most, the owners of capital, seem to like it – the way a junkie seems to like heroin. It may be destroying him, but the euphoria blots out other considerations. In Closing: Some Thoughts on Gold We will close with two separate thoughts about gold. These thoughts should be kept separate, as far too often proponents of buying gold (e.g. dealers) mix up monetary economics with the driver to buy the metal. One, in a free market for money (aka gold standard), no one has the power to manipulate interest rates, hence asset prices, yield purchasing power, and discount rates. The time preference of savers has real teeth. This is the principal virtue of the gold standard (not static consumer prices, aka inflation, which are neither possible nor desirable [Readers may want to review our in-depth discussion of the pitfalls of the “Price Stability Policy” in this context – PT]). Two, the falling marginal productivity of debt and falling discount is pathological. If one wants to avoid (well, minimize) one’s exposure, then one buys gold. Not out of hopes of a higher price (and the same seed-corn eating process of speculation described above). But simply as the alternative to equities with too little discount, and bonds with too little interest. Charts by: StockCharts, Monetary Metals Chart and image captions by PT
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