The future will be different for our investments
Updated: Sep 16, 2018
In the next decade, we are probably going to experience a scenario we have to go back in time almost fifty years in order to find a similar one. It will be something impacting almost any businesses and investments and it is likely to last more than a decade. It is something few of us experienced in our lives as investors or savers but, it can be faced with confidence and patience if we are equipped with assumptions and game plans that we can adjust along the route.
The scenario we are describing is the one with rising interest rates decreasing the valuation of our assets despite their potential positive and growing cash flows. However, lower valuations do not mean necessarily lower returns; good opportunities will still be available in almost any type of investments but, we need the right focus.
First things first, we are not able to predict singularities or tail events so, predicting whether and when there will be another debt crisis or similar events is out of our reach. Although some may think that anticipating another debt crisis is not a tail event, we want to focus on trends rather than events. Exploiting trends is easier because of their lower dependency on timing.
Our discussion will be focused on interest rates even though it is hard to talk about them without mentioning inflation in any dynamics. However, we will add consideration on inflation and interest-rates in our following post "Bonds, stocks, houses: which investment protects us if inflation takes off? ".
Let us go back in time about fifty years. We will use the US financial market as example because of the availability of data but, the argument holds for almost any other investments.
Let us think about all US corporations as one big company, their collective profits as its annual cash flow (about 10% of US GDP) and the multiple Price over Earnings ratio, or PE ratio, as the valuation of the investment as a whole; we are assuming the long-term PE ratio as a correct valuation (i.e. a PE ratio of 10 means investors are getting each year 10% return from cash flows on their investment paid 10x those cash flows - see post “How to value any investment”). The interest rate we will use as reference or required return is the 10 year Treasury rate.
As the first picture below shows, reference rates increase from single-digit levels to about 15% during the 70s going into the 80s (blue line). In the same picture, corporate earnings rise continuously from 1960 until recent days, despite specific downturns (red line). Interest rates then change trend in the early 80s decreasing continuously till recent days.
The steep rates' increase during the 70s decreases businesses' valuations as shown in the picture below by the historical PE ratio. That happens despite growing corporate earnings as shown before. Investors were basically requiring higher returns on their investments because they had investments with higher returns as alternatives, represented for example by the 10 year Treasury (we should also adjust for the extra risk). Therefore, investors were willing to pay less for those cash flows in order to realize higher returns on their investments.
It is implied investors thought (or realized) corporations were not able to “index” their earning margin to inflation; therefore, stocks were acting more like bonds. More on that in our post "Bonds, stocks, houses: which investment protects us if inflation takes off?.
During the 70s there were corporations investors could invest in for a PE ratio of about three, meaning investors were paying three times cash flows obtaining a return of about 30% per year. Also, as per the corporate earnings trend, many of those corporations were healthy ones surviving recessions and growing their earnings. Once rates decreased during the 80s, those cash flows where valued even more because discounted at lower rates. Thus, capital gain (appreciation) increased the total return once summed to the return from cash flows that the investor was already getting on the initial investment.
Many aspects of the scenario we just described are likely to repeat in the decade ahead of us, even longer. In general higher rates represent higher risk and inflation and those phenomena exchange roles of cause and effect. A lot could be said also about specific historical geopolitical and economic conditions. However, in times of volatility and/or inversion of trends, there is the usual tendency of inventors to overreact, overbuying or overselling; focusing on returns and cash flows is the only way to assess the real potential of investments.
Generalizing the concept, we should always think about the return we get vs what we pay, even forgetting about interest rates. However, having an assumption and idea on the possible scenario ahead of us helps us deploy patience, something that is getting lost considering the times of appreciation we come from. In the future, there will be probably low short-term return from assets’ appreciation (thinking about consistent investment strategies and returns), however, good returns may still be possible if we focus on the real cash flows from investments. This is not just a mere financial discussion; major successful investors and savers have built in time their success on long-term trends. Despite noisy daily market updates with often accidental ties to economic conditions, long-term and fundamental trends will likely determine the success of any investments: houses, private businesses, retirement funds, private equity & venture capital investments, financial markets … it is just about cash flows compared to our required returns.
This post is not, in any way, an investment advice
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