Some Musings on a QE3 World

Executive Summary: The battle between deflation and inflation endures – we believe it is prudent to position for asset deflation and currency inflation. Stock markets have been significantly impacted by QE and remain generally overvalued and dangerous – we believe it is prudent to continue to underweight our stock market exposure.

The Details: Regarding the now age-old debate (well, for at least four years now…) between deflation and inflation (which, we might add, materially guides how we allocate your investments)… well, it is still ongoing.

To us, the real imminent threat is still deflation of asset prices and we see this in housing prices and many consumer products where demand is falling. We likely would have seen it in stock markets if it were not for massive and consistent central bank intervention. To that point, the central banks seem willing to not only tolerate higher inflation but actually seem to be wishing for it.

Alas, this is a very thin line (and a dangerous one) to walk and our concern is that given the sheer size and amount of central bank money propping up and distorting the bond and stock market, monetary inflation could easily go too far and flip out of control into hyperinflation. We hope it goes without saying that it is our wish that they know when (and how) to stop, but we’re not ‘betting’ on that outcome as the one with the higher probability. It simply wouldn’t be prudent. We’ll position the portfolios accordingly.

For details and an update on our current portfolio design, please contact us via email or at 613-727-0171.

Mohamed El-Erian from PIMCO recentlywrote:
(Financial Times article, Sept 20th, 2012)

“with the political process hindering meaningful reforms and refusing to sensibly allocating principal losses, the temptation to resort to “somewhat higher” inflation is unquestionably there.”

Other countries like Japan and Brazil most recently have resorted to their own monetary expansion policies to counteract the Fed’s actions (which imports inflation into those countries) and the rise in their domestic currencies thereby eroding their competitiveness.

The central banks are using monetary policy in an attempt to change asset prices (i.e. housing and stock markets) hoping that this will spur economic growth. Well, this flips conventional (at least at my business school) thinking around where asset prices were considered a leading indicator of economic growth… not a causal agent for economic growth. This is troubling in that we believe it causes distortions in true asset valuations and leaves us precariously exposed to the popping of those asset valuation bubbles.

It would be tempting to chase stock market returns in this situation but we’ll resist, remain disciplined, and we will maintain our exposures to equities but not add to them at this time.

You might wonder why have stocks moved up so much like this?

Well, we’ll try to explain…

  1. The first reason is that newly printed, out-of-thin-air money is injected into the banks who, rather than lending it out, trade it as their own capital thereby driving stock prices higher.
  2. The second reason is more quantitative in nature and brings me back to basic securities analysis 101. That is, the lower the interest rate, the lower the discount rate used in the valuation models for stocks. Remember, a company’s stock is pricing in the discounted present value of all future cash flows of that company. You discount these future cash flows (i.e. future profits) using an interest rate (the risk-free rate of short-term government debt is typically used) and the lower this discount rate is, the higher the present value figure is at the end of the computation.

So, low rates equals low discount rates equals high discounted present value of future cash flow calculation equals high stock price valuation.

Yes, it’s really that simple.

David Rosenberg from Gluskin Sheff wrote recently:
(September 19th, 2012 “Breakfast With Dave”)

“the Fed has completely altered the relationship between stocks and bonds by nurturing an environment of even deeper negative real interest rates. Therein lies the rub. The economy and earnings are weak and getting weaker, but the interest rate used to discount the future earnings stream keeps getting more and more negative and that in turn raises the future profit expectations. The fact that the S&P dividend yield is triple the yield in the belly of the Treasury curve has also lifted the allure of equities, or at least those that have compelling dividend yield, growth and coverage characteristics.”

We found David’s research in his September 19th missive very interesting. He further stated that the correlation between stock returns (S&P500) and QE (money printing) is very high at 0.86. Wow… that’s incredible. But that’s not it… His further regression analysis showed an R-squared of 0.74 meaning that, and get this, over 74% of stock market movement can be explained by the level of the Fed’s total assets (QE – money printing) alone since QE1 started.

We’ve suspected this for a long time and we’ve told many of you about this at our meetings, but it’s nice to provide the statistical evidence/analysis to back this up.

This further reinforces our current portfolio positioning. We are very confident we are on the right track.