Sunday, November 17, 2013

What ‘Tapering’ means to the Canadian Diversified Investor

Over the years, many posts on this blogs have tried to outline ways of valuing stocks, constructing a truly diversified portfolio, and about buying and owning stocks of healthy companies at a good price while ignoring most of the market hysteria.  ‘Tapering’ is another one of those market hysteria things that creates volatility for the trader but is of no major consequence for the investor.  The reason for ignoring the ‘tapering’ hype is simple. Tapering is a way to keep interest rates low and adding stimulation through increased money supply to the overall economy. It also bails out banks.  At least, that was the intend of QE3 and the $85billion monthly bond repurchase program. Whether ‘tapering’ and QE_so-many helps depends on whom you talking to.  A number of experts state that the bond buying programs help banks get rid of bad debt and replenish their capital, but that those same banks do not spread out the money to lenders elsewhere in the economy and thus there is no real economic stimulus.
Others claim that all the Fed action has created or will create is inflation. Problem, with this theory is that the consumer is not on a buying spree and no price inflation is in sight.  Today, much of the increased corporate profits are from profit margin improvement due to more efficient production methods as well as due to the low cost of credit. Yet, revenue growth (i.e. sales) have not dramatically increased. Thus companies have no significant pricing power which often drives price-inflation. To create price-inflation we need higher consumer confidence and more consumer spending, i.e. higher product demand. Thus there is no price inflation (yet).
On the other hand, investors who want income in this low interest environment are hunting for yield from dividends or from real estate (rental income) and whatever other cash flow they can lay their hands on. Thus over the past 5 years, the only secure ways of achieving respectable cash flow has been investing in dividend paying stocks and in rental real estate.  As a result, from March 2009 onward we have been climbing a wall-of-worry in the stock and real estate markets – a bumpy wall of worry to understate it a bit. The price increases in these assets are due to rising corporate profits and due to increasing rental net income.
But we also start seeing that the valuation of these cash flow generating investments have gone up. Now $1 of net cash flow does not require a $10-15 investment as in 2009 but rather a $15 to $30.  Or in terms of P/E now the market values a typical stock around 14 to 15 times its net earnings rather than 8 to 12x as at the bottom of the market in 2009. This has resulted in significantly increased asset value inflation. An obvious example off asset value increase is the price of gold since the early 2000s.  But on a historical basis, stocks are currently not over-valued; stocks are in the average range of valuation measurements such as P/E or price/book ratios.
U.S. Real GDP is currently growing at a modest 2-2.5% but will likely improve to 3-3.5% at which time the end of quantitative easing have occurred. Bernanke, and now Janet Yellen, seems not willing to significantly reduce monetary stimulus until the unemployment rate has fallen below 6%. In the U.S. the unemployment rate is now approximately 7%. Just like in Canada, the unemployment rate is measured as a percentage of the number of people that are willing and capable to work. This latter number expressed as a percentage of the overall population, called the participation rate, is still declining.  So for the unemployment rate to really fall below 6%, not only do we need more jobs for the current number of people participating in the economy but also we will need jobs for those people that have given up looking for work plus new immigrants plus young people that finished their education and that join the work force.
Thus, ‘tapering’ is still some time off. But what does ‘tapering’ mean?  Well it means that the U.S. Central Bank (or Fed) starts to REDUCE the amount of bonds it is buying back; initially that may mean a monthly reduction of purchases from $85 to $75 billion per month and this does not even affect interest rates. Remember, the Quantitative easing measures did not start until after (short term) interest rates in the U.S. hit rock bottom (i.e. 0%)  So the ‘tapering’ or reduction of monthly bond repurchases from $85 billion to zero may take by itself at least a couple of years and it will not be done until the economy has improved significantly more. Well an improved economy means higher consumer demand and thus higher corporate pricing power, revenue and… yet more profits.  So even if the fed tapered, it would be done in such a fashion that the effects of tapering are offset by a stronger economy and thus provide yet higher corporate revenue and possibly even higher profits!
No, tapering and rising interests may be risky for the bond markets but not for the stock markets – at least not in the near future.  The real risk for the stock market is the threat that investors become over-confident and the price stocks get too high when compared to how much the underlying companies earn. The real risk is an exuberant and, euphoric bull market and as outlined in OUTLOOK 2014, we’re not there yet. 

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