Aug. 15, 2016 11:14 AM ET
- Financial theory tells us that as the discount rate goes down asset prices go up.
- Central banks are artificially pushing asset prices higher with their zero interest rate policy.
- Monetary policy has failed to create jobs but has increased disparity between rich and poor and unfairly transferred wealth from savers to debtors.
- The problem is not that asset prices are overvalued. The problem is that nobody wants to have money because it is worthless.
- Central Banks are dangerously pushing citizens’ trust in fiat currencies beyond the limits.
Remembering the Basics of Asset Valuation
There are several methods to value an asset, but most of them use a combination of future expected cash flows and discount rates. For example, the Gordon Growth Model goes like this:
On the one hand, the higher the expected future cash flow (CF1) or the higher the growth rate of that cash flow (G), the higher the value of the asset. On the other hand, the higher the discount rate (R), the lower the value of the asset.
The issue with asset valuation is that small changes in the parameters (CF1, r, g) can lead to completely different outcomes. In fact, you can justify almost any value by playing with the parameters, so don’t put too much faith on price targets.
Still, asset valuation is useful for comparison purposes (across time and sectors or within a certain industry). Simulations and sensitivity analysis are also useful for understanding the impact of a change in a parameter on the value of the asset.
Which discount rate should be used?
There’s no easy answer to this question. In fact, some investments are riskier than others, some investors are more risk averse than others and some regions have higher interest rates than others.
I use the WACC (weighted average cost of capital) which goes like this:
This formula shows that as Central Banks lower interest rates, the risk free rate comes down and so does the cost of equity, the cost of debt and the WACC. As we saw in the Gordon Growth Model expression, as the discount rate goes down, asset values go up.
Putting a 25 basis points interest rate cut into perspective
Let’s say you’re valuing an asset with a $10 CF1 with 0% growth using the Gordon Growth Model.
Using a discount rate of 10% you would get a $100 value. If you cut your discount rate by 25 basis points to 9.75%, you would get a $102.5 value. The difference in value is only $2.5 or 2.5%.
Using a discount rate of 1% you would get a $1.000 value. If you cut your discount rate by 25 basis points to 0.75% you would get a $1.333 value. That’s a difference of $333 or 33%.
In fact, cutting interest rates by 25 basis points from a starting point of 10% has a minor impact on asset values, but the same 25 basis point cut from a starting point of 1% has a major impact in asset values.
Are Central Banks creating a bubble?
As Central Banks have kept interest rates at virtually zero (and now even negative) for the last 7 years, the risk of a bubble in asset prices (from bonds to equities and real estate) is quite high.
In fact, if you try to discount those $10 CF1 with 0% growth at a discount rate of 0%, your calculator will say “error”. But if you use a 0.00000…1% discount rate, you would get a number close to infinity. This quick exercise shows how I feel about current asset prices in general. It’s all about Central Bank’s policy.
As Warren Buffett said in an interview to CNBC in May, “If the government absolutely said interest rates are going to be zero for 50 years, the Dow would be at 100.000”.
Is the current Price Earnings Ratio justified?
The Shiller PE ratio, also known as cyclically adjusted PE ratio, is based on average inflation adjusted earnings from the previous 10 years.
Looking at the graph, the immediate conclusion is that equities are overvalued from an historical perspective. This comes with no surprise because as we’ve seen in the previous chapters the discount rate is today much lower due to the loose Central Bank policy. As a consequence the same earnings (CF1) are today worth much more (V0).
However, unless you think interest rates will remain at zero forever, you should be careful before discounting future earnings using all time low discount rates. In fact, as we’ve seen in a previous example, a 25 basis point change from a low starting point in the discount rate has a tremendous impact on asset prices.
What is the likelihood of an interest rate hike?
Very low. We’re more likely to see further easing in the UK, EU, Japan, Australia or New Zealand (just to name a few) than the opposite.
Still, after 7 years of monetary easing we have to ask if it is working or not.
As I mentioned on the money printing drug, this monetary policy has failed to fuel a job recovery. In fact, if you’re curious enough to look beyond the unemployment rate statistics you’ll see that the labor force participation rate keeps getting lower:
Source: Trading Economics
There’s also clear evidence that this monetary policy has increased economic disparity between the rich and the poor at the same time it has unfairly transferred wealth from savers (who are usually Families) to debtors (who are usually Companies and Governments). This is the exact opposite of what Government policy should do.
In fact, if you’re a rich person and have a lot of assets (bonds, equities and real estate), this zero interest rate policy is working quite well for you. And if you took a lot of debt to buy those assets, this policy is working even better.
But if you’re a common citizen leaving some cash aside every month for a bad day, all you know is that the interests you used to receive from your savings account are getting smaller by the day and don’t even cover the inflation rate.
2 perspectives of the same problem
Some will say that bonds, equities and real estate are not worth the current prices and are overvalued.
Others will say the problem is money which is worth nothing. I rather see the problem this way and that is why I think gold (NYSEARCA:GLD) (NYSEARCA:DGP) (NYSEMKT:GTU) (NYSEARCA:IAU) (NYSEARCA:PHYS) (NYSEARCA:UGL) (NYSEARCA:SGOL) is part of the solution.
Actually, I think the current historically high PE ratios in the stock market and the skyrocketing real estate prices are the early signs of investors losing trust in fiat currencies.
Could citizens lose trust in these Fiat Currencies?
Here’s something to think about: why should citizens trust in a currency that consistently loses purchasing power every single year? Why should we want to own a currency when the interest rates we receive don’t even cover inflation? Why should we keep a currency whose monetary policy “takes from the poor and gives to the rich”?
Since last week, Raiffeisen Bank in Germany has started taking back 0.4% from their retail customers for the savings in excess of €100.000.
I think Central Banks are playing with fire and dangerously pushing beyond the limits of citizens’ trust, confidence and acceptance of these fiat currencies. The thing with trust is that it takes years, decades even centuries to be built and when it’s lost may never be recovered. Also, the loss of confidence in the currency is something that could happen very quickly, leaving Central Banks no time to react.
As I mentioned in a previous article, history reminds us that all fiat currency experiments have failed due to excessive “paper” money printing. Despite Government attempts to enforce those currencies, all these currencies went out of favor and lost acceptance by the population. Could this happen again? Where will people turn to put their savings? Gold? Bitcoin?
Is Gold a valid alternative to Fiat currencies?
Let’s start with a reminder of the 3 main properties of money and see if Gold meets the requirements.
First of all, money is a medium of exchange, so it has to be widely accepted. Without money, society would have to rely on the barter system to trade goods and services which is inefficient as it requires double coincidence of wants and needs.
Gold has performed this role in the past and until very recently. In fact, the first coins go back to Greece, Persia and China in the 6th century BC. Furthermore, the replacement of Gold by the dollar after the second world war was only possible because of the guarantee of the dollar convertibility into Gold. Without that convertibility it wouldn’t have been possible to enforce the widespread acceptance of the dollar (as well as any other fiat currency). The important point here is exactly this one: Fiat currencies needed a Gold guarantee in order to be accepted (not the other way around). So yes, Gold can perform this task even if this is not (yet) the main problem of fiat currencies today.
Second, money has to be a unit of account. In the barter system the price of milk was quoted in units of bread which is inefficient, confusing and allows arbitrage.
Once again, Gold has performed this task for centuries and until very recently. Furthermore, it performs this task better than fiat currencies because it doesn’t suffer from inflation as fiat currencies do (so prices are more stable).
Finally, money has to be a store of value, or in other words, it has to maintain its purchasing power over time. In contrast to fiat currencies that have to pay an interest rate equivalent to the inflation rate in order to meet this requirement, Gold performs this task quite well.
In addition to these, Gold has centuries of history backing it (not a few decades as the current fiat currencies). Also, it surpasses all regions in the world, contrary to fiat currencies whose reach rarely goes beyond its country of origin.
So, why don’t we use Gold instead?
No, the problem is not operational. In today’s society where the share of electronic payments is growing, you can easily pay in a restaurant abroad in euros, dollars, yens or even bitcoins. So, would it be so difficult to pay in Gold from your bank account?
The reason we don’t use Gold today is that we perceive fiat currencies are able to meet the 3 properties of money mentioned before. Well, maybe not the Venezuelan Bolivar…
That perception could change very quickly. As Europeans start paying for having their savings in the bank, as Americans realize they have been losing more than 1% of purchasing power per year over the last 7 years for having money in the bank, as house prices increase double digits per year, maybe that vision is not as far as we think.
Gold will carry on rallying as the trust in fiat currencies fades away.
Disclosure: I am/we are long GOLD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.