Are equity and bond prices held by feathers and wax?
I recently spent some time reading a great article from Tyler Durden of Zero Hedge. You can read it here.
I happen to agree with the content and views, but I was delighted to see a pithy quote from a Bank of America strategist which referenced one of my favourite stories - the Greek tragedy of Icarus.
As the story goes, a renowned craftsman and inventor of the labyrinth called Daedalus once crafted himself and his son, Icarus, a pair of feathered wings. It is said the feathers were glued together with wax. Forgetting his father's warning (not to fly too high, nor too low) and brimming with confidence, Icarus flew too high and too close to the sun. The hot sun melted the wax, the feathers came apart and Icarus plunged to earth. The end of this Greek tragedy? Icarus drowned in what became known as the Icarian (aka Aegean) Sea.
How apt it is to remember this lesson when we look at bonds and equities today, particularly the big NASDAQ growth stocks.
Amazon trades on a PE of 249 with Netflix trading only 13 annual turns lower at 236. These after-tax multiples suggest investors are currently prepared to discount the future cash flows of those businesses by a measly ~0.4%, which is less than what a 1 month US Treasury Bill (T-Bill) is returning after tax.
There are many more Icarian examples on NASDAQ, the NYSE and other exchanges. Many are awesome businesses with almost no revenue boundaries given cloud enablement and because digital businesses do not take weekends or holidays. Many have nominal profits but massive operating cash flows and an ability to borrow cheap. Many have chosen reinvestment ahead of profits in order to generate higher growth in revenues.
Valuations for many of these are well outside the moon's orbit and nearing the sun.
Perhaps the current crop of Icarian flyers will not be disrupted once better and/or more innovative offerings are brought to market. Perhaps their profits will continue doubling, as Amazon's is predicted to do in 2018, until eventually their PEs float back down to earth.
I am not so sure, but let's get back to Durden's article.
Durden references comments made by two prominent sources (a hedge fund CIO and a Bank of America strategist). The comments relate to what each felt were the biggest market risks at this time.
In short, both pointed to global central bank liquidity and technology disruption.
In terms of the first point, the logic is that if a jump in wages is not seen in the US, yields will not go up due to the US Federal Reserve (Fed) waiting for inflation to phoenix. In turn, asset price increases will accelerate and presumably some time in 2018, the Fed will need to reach for the needle and pop the asset bubbles - essentially, a nightmare scenario, in their opinions.
As to technology disruption - robots and artificial intelligence (AI) are mentioned and to that list of applications I would add the internet of things (IoT). I would also add a list of enablers (i.e., the picks and shovels) including super quick processors (think Nvidia) and the three leading cloud platforms.
These advances are disrupting the labour market, increasing margins for adopters, and providing consumers with cheaper and more convenient consumption choices. As China accelerates full tilt into consumption mode within an open and inclusive Xi-run China, the breadth and depth of innovative offerings should only become more plentiful.
However, looking for material inflation right now in the protectionist and exclusive Trumpian US, or the QE Infinity fuelled EU, is like trying to find the real Wally among the fakes. Still, Trump's tax cuts, if approved, may underscore upward price movements for consumers (and share prices), but we shall see.
Take home point, the Fed no longer has control over inflation, but appears to still be waiting to see it jump the 2% hurdle before upping yields.
But wait a minute. The Zero Hedge article made no mention of a comment made by another prominent player. To be fair, it was a comment made back in August at the Jackson Hole economic symposium. That comment came from Dallas Fed Chief, Robert Kaplan. You may recall Kaplan suggesting that old economic models might be out of date.
Kaplan implied that 'structural' technological disruption was likely an anti-inflationary construct, and something that was not present at the time the old economic models (read Phillips Curve) were crafted.
I have no doubt the Federal Open Market Committee (FOMC) of the Fed realises the sun is getting hotter. After all, it was FOMC under Ben Bernanke which turned up the heat in November 2008. Nonetheless, while the Phillips Curve and pre-tech disruption thinking may no longer be relevant, old habits die hard, and it is an old habit which has so far blinded a Fed that is desperately seeking a specific level of inflation.
The US Fed balance sheet run-off which started this month is a capital account normalisation. It will effect international money flows at the same time as restoring the Fed's 'dry powder' for future potential meltdowns. This assumes we actually get to the targeted $50 billion per month in aggregate redemptions and continue towards astute normalisation. However, to really move the risk needle and asset relativities, FOMC needs to get hawkish and put a rocket under yields.
Maybe they do, maybe they don't, but at the moment are high asset prices justified, or are they a bubble of feathers and wax? The answer is that it doesn't really matter for long-term investors or for those able to mitigate the risk, but for almost everyone else, it certainly can't hurt to heed the warning of Daedalus.