As we near quarter’s end, we see a dramatic shift out of the technology leaders of 2020. This handful of companies has not only driven market averages to new highs but they, themselves, have each attained historically high value metrics—like earnings ratios and cash flow multiples and price-to-sales ratios. Rather than steering into an esoteric discussion about valuations and metrics, let’s focus on more meaningful “macro” questions that may better explain our current environment.
First, let’s try to define the common determinants of valuation in our world to see if many of the market’s present fears make sense. Our assumption is that investment money will always flow out of overvalued assets and into undervalued ones.
An assumed interest rate is probably the most important determinant as it represents an “all in” quotient to be used to project company earnings or cash flows, or to calculate the present value of future flows. As interest rates represent the price at which a lender is willing to lend, that lender is hoping to receive a satisfactory rate of return after paying all taxes and covering the cost of inflation. Accordingly, taxes and inflation have a direct effect on interest rates, which in turn affect price earnings multiples and other components of the valuation process. In simpler words, higher taxes and higher inflation each have a negative effect on stock and bond prices. The higher the valuation—the greater the decline potential for stocks. Bond prices will drop proportionately to interest rate increases. There are times, therefore, when stock and bond prices move in tandem, and we appear to be in the midst of such an experience.
Inflation is known to occur when “too much money chases too few goods.” Accordingly, the Biden plan of spending $2 trillion for COVID relief is beginning to stir Wall Street participants into thinking about “too much money” while looking ahead to more “green initiatives and infrastructure spending;” all of which will clearly add up to “too much money chasing too few goods.” Accordingly, many on Wall Street are now predicting higher inflation. Bonds have responded with a precipitous decline along with the high price/earnings technology stocks. We are off and running with an inflation scare; a global one at that.
At Cadinha & Co. we have a different view of inflation and are inclined to lean into this inflation wind that has started blowing.
In a fractional reserve banking system like we have in the U.S., each newly printed dollar is deposited to a bank. The bank keeps 10¢ for reserves that are required by law, and loans out the remaining 90¢. That ninety cents is deposited to another bank which reserves 9¢ and loans out 81¢, which in turn ends up in a third bank. If we follow the results of that first deposit, there is a multiplier effect that multiplies that dollar into a larger figure, say $10. This multiplier effect tracks the supply of money as to how quickly it multiplies, and how many times it multiplies. The demand for money, however, is tracked by the “velocity” of money. By following the velocity and watching Federal Reserve open market activity, we can gauge whether there will be “too much money chasing too few goods.” Further, by comparing our velocity with that of other nations, we can gain insight into the relative value of our dollar. The value of our dollar will have an effect on commodities and other assets which are denominated in dollars.
The velocity of money has been dropping like a stone in a clear mill pond. Dr. Vic Canto, our highly regarded economist, believes that there is a “loan suppression effort” conducted by the Federal Reserve regulators to effectively cut down the multiplication of money. In other words, our banks can’t freely loan the excess money, and instead have chosen to hold excess reserves in their bank. These excess reserves have been reported by the Federal Reserve Bank of St. Louis for many years. Interestingly, as of the end of 2020 they no longer report these numbers; but, our last look revealed excess reserves of nearly $2 trillion sitting in banks. Dr. Canto further believes that there is an effort in place designed to control the amount of money in the system, while at the same time, printing money freely to provide the needed liquidity to our Credit System.
To an analyst that simply watches the Federal Reserve’s open market activities, it’s easy to conclude that we’re heading into much higher inflation. A further look at velocity, however, tells us a different story. We will likely lean into the wind as it stirs up inflationary dust. The truth will become evident in a few months. In the meantime, it might be a bumpy ride.
Lastly, what do banks do with excess reserves? They buy U.S. Government debt, so there is a big buyer out there prepared to loan us our deficit. Pretty slick, huh? Right out of the Peruvian and Argentinian playbook.
We view this as an opportunity to position portfolios before the market takes off again…buckle up!