Stocks rose on Friday. Both the S&P 500 and the NASDAQ Composite set new all-time highs, while the Dow was shy by just about 7 points.
Stock prices should represent the present value of future expected cash flows to investors. Even when one is buying a stock that doesn’t pay a dividend, the presumption is that some day in the future it will. Microsoft# and Intel# didn’t pay dividends two decades ago when they were surging, but both pay healthy dividends today that grow each year. Procter & Gamble# has not only paid dividends regularly but has raised them for over 60 consecutive years.
In valuing stocks, earnings per share are used as a proxy for cash flow. The P/E ratio is the proxy for a discount rate, the factor that adjusts the stream of future cash flows back into today’s dollars. The discount rate is closely tied to the consensus expectation for the future rate of inflation and parallels the yield on long term bonds.
Since the days of Paul Volcker, interest rates have been falling and P/E’s, on average, have worked higher. We have witnessed intervening recessions that resulted in sharply lower stock prices, but those related more to collapsing earnings than rising inflation. In times of doubt, of course, risk levels rise, and for rather brief periods, the discount rate applied to equities can rise as well. Thus, in 2008, we witnessed a double whammy of collapsing earnings and rising discount rates. Over longer intervals, however, earnings have generally risen, and at least for the past 35 years, interest rates have fallen in line with steady reductions in inflation expectations.
Followers of the Federal Reserve and monetary policy may have heard much discussion of the Phillips curve named after an economist who did much academic work tying the rate of inflation to the unemployment rate. The theory strongly suggests that as an economy approaches full employment, employers will be forced to bid more aggressively for workers, thereby increasing inflationary pressures that will pass through to the entire economy. When the Great Recession peaked, unemployment was over 10%. Including those partially employed or in jobs that were below their skill levels, the unemployment rate was closer to 20%. No one knows precisely the level of unemployment that coincides with a shift in bargaining power from employer to employee, but most have felt, historically, that once the official rate falls below 5%, some inflationary pressure should kick in. Below 4%, the theory would suggest that wages should be rising meaningfully higher than the rate of inflation. Therefore, once unemployment gets below 5%, it would stand to reason, at least to believers of the Phillips curve, that rising wage pressures would lead to higher inflation. With the unemployment rate moving close to 4% today, increasing inflation should be at hand, or so the theory goes.
Indeed, there are signs that wages are rising. Some suspect, on an apples-to-apples basis, they may even be increasing at a rate close to 4%. The numbers the government provides when it issues the monthly employment report suggest fairly steady gains closer to 2.5%, but those numbers ignore the fact that as expensive boomers retire, they are replaced by lower paid millennials. Thus, there is a bit of a negative bias in the government numbers.
Nonetheless, the logical conclusion of those advocates of the Phillips curve would be that we should be seeing rising inflationary pressures now. But, at least so far, we have not. Why?
I will offer you three reasons:
- The world is more global today than ever before. People and companies can search worldwide for the lowest cost of production. If a shirt can be made for $20 in Malaysia, a company cannot survive making shirts in the U.S. for $30. Modern manufacturing and lower shipping costs can allow a U.S. company to produce at a modest premium, but only a modest one.
- Inflation has been missing for a generation. Younger workers are more accepting of modest annual wage increases because they know of no other way.
- Most important by far, however, is the impact of the Internet. The Internet doesn’t necessarily keep wages low, but it keeps prices low. If you want a widget, in a matter of seconds you will know who sells it at the best price. Will you pay a premium for convenience or some other reason? Sure you will. You aren’t going to drive crosstown to save $0.05 per gallon on gasoline. But if you are a trucking firm that buys thousands of gallons of fuel, you will bargain your supplier for that nickel. The lack of pricing power forces manufacturers to become compulsive about lowering costs. Part of that can be efficiency and part can come from automation.
Thus, the $20 shirt of a decade ago is probably still $20, or maybe less. I can say the same about many goods. You might ask “what about the iPhone”? But the iPhone 10 years ago had only the fraction of the capability of the phone today. 10 years ago, it was a phone that played music and could retrieve your emails. It had a crude camera (but no selfies!). Serious apps came later. No ApplePay because near field communications didn’t exist. No finger print detection either. You get the point. Almost every product that is higher in price today is higher because of enhanced features. Granted, service prices have crept up as wages have risen, but even here, price discovery limits the increase. If the landscaper wants to charge you $25 more per week to mow the lawn, two clicks on your computer and you find someone else who will do it for less. Technology has also driven down the costs of doing business. Internet retailers don’t have to support expensive stores or carry redundant inventories. Technology simply creates lower cost models. Uber didn’t exist 15 years ago because there were no smart phones and limited GPS capability. Event tickets are bought and delivered electronically. No printing and no mailing expense and far lower personnel expense. There are no more paper stock certificates or airline tickets. Restaurants that don’t take cash may lose a few customers, but the cashier can’t give his buddy an extra burger, and there is no cash to steal.
The obvious question is whether the technological benefits have reached a peak and my rather obvious answer is hardly. Even when you think nothing new can come along, it does. Airbnb? Houzz? WeWork? Every new idea today has some sort of technological base, and everyone uses technology in some way to lower costs.
There is one other factor to consider and that is the excess of money. What do I mean by excess? There are close to $2 trillion in bank funds deposited at the Fed earning a fraction of a percent because the banks have no current alternative uses for the funds. Simply said, there is more supply of money available to lend than demand to borrow said money. That means interest rates stay low. The Fed can force short term rates higher, but only so far without causing economic pain and reducing demand. The excess funds also suggest that central banks can reduce the collective sizes of their balance sheets without forcing inflation higher, at least until some of the excess money is soaked up.
Never before have we faced a time where technology change was so profound, at least as it relates to price discovery, combined with an extraordinary excess of capital, and the legacy of the worst financial collapse in 70 years. It isn’t that the Phillips curve doesn’t work. It’s that the impact is overwhelmed by other factors (and perhaps more that I haven’t mentioned). Certainly, it hasn’t hurt, for instance, that commodity prices have remained low, courtesy of excess capacity. Indeed, except possibly for labor in the developed world, it is hard to find any shortages. Sure, there will come a point when employment gets so tight, and excesses get more completely absorbed, that inflation will surprise us to the upside. But I don’t see that time happening real soon. Maybe it is a year or two away, maybe longer. 2018 inflation may be a tick or two higher than this year. But we have been saying that for a long time. Perhaps the better strategy for investors is to wait for at least some small sign before getting too upset. To be sure, we have seen a little rebound in a wide range of commodity prices over the past few months that have affected top-line CPI. I still don’t see any market which one can call tight. As long as inflation is tame and earnings growth is at or above historic averages, stocks can continue to rise in price.
Today, Kelly Ripa is 47. Sting is 66.
James M. Meyer, CFA 610-260-2220
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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
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