Deutsche Bank’s ace stock market strategist David Bianco—a friend of mine and formerly a colleague—has devised a nifty new ratio to summarize the health of the U.S. economy. He calls it the Golden Ratio; I call it the Bianco Golden Ratio. It is real GDP growth / the inflation rate. More formally:
Yr/yr percent change in real GDP / Yr/yr percent change in CPI
David reckons that when that ratio is 1.6x or higher—for example, with GDP growth of 3.2% and inflation of 2%—the economy is in good shape. At such times, he writes, “productivity and capex are strong, interest rates are benign while providing decent returns to savers, and risk premiums are low and the job market is vibrant with prosperity gains broadly shared.” In general, PE ratios tend to be higher when these conditions prevail and the Bianco Golden Ratio is high. A few examples:
- In the wonderful early 1960s (1961-65), GDP grew 5.1%, inflation was 1.3% and the Bianco Golden Ratio was a sky-high 3.92. In these years, the trailing PE of the S&P 500 averaged 18.8x.
- In the awful 1970s (1974-79) GDP – boosted by a surge of women and baby boomers into the workforce – grew 3% but inflation was 8.5%, so the Golden Ratio was an abysmal 0.4%. PE’s were very low, averaging 9.4X and just 8.4X if you exclude recessionary periods when PE’s were boosted by depressed earnings.
- In the late 1990s (1995-99) GDP grew 4.1%, inflation averaged 2.4%, the Bianco Golden Ratio was 1.9x, and PE’s averaged a lofty 21.2x. Obviously a bubble developed late in the decade; before then, in 1995 and 1996, PEs averaged 16.2x.
Crappy Economy, High PEs—Huh?
Against these three earlier periods, the current situation is anomalous—crappy economy, high PE ratios. Since the beginning of 2011, GDP growth has averaged a pathetic 2.1% and inflation is about the same, 2.2%; therefore the Bianco Golden Ratio is about 1x. Despite this poor performance, PE’s have averaged a fairly high 14.7x since 2011 and—more importantly—over the past year the S&P 500 PE averaged a lofty 16.9x.
So why are PE ratios high despite poor U.S. economic performance? That’s a complicated question with several answers. Better than average corporate management, and share-holder friendly use of cash are important. But the cause I would highlight, and the one conventional economists continue to miss, is: Regulatory mismanagement is restraining economic growth, especially employment growth, which is prompting the Fed to keep rates low, forcing investors to buy stocks to get a decent return. I still see no evidence Chair Yellen has figured this out.
Looking at the litany of regulatory blunders by the Obama Administration, arguably the most egregious is failure to reform corporate and individual taxes, despite bipartisan desire to do so. The Stimulus had some Keynesian logic, even if it became a slush fund for Democratic special interests. Dodd Frank may be a monstrosity, but Wall Street did need reform. Obamacare may be one of the worst laws in American history, but expanding healthcare access is a worthy goal.
On the other hand, refusal to reform America’s antiquated corporate tax code – with its excessive rates and global incidence that force firms to keep trillions of dollars offshore—is pure negligence, born of Obama’s anti-capitalist ideology. The President simply hates the idea that, properly incentivized by a rational tax system, companies can do good (like creating jobs) while doing well. His reform proposals have all centered on taxing the foreign profits of U.S. firms, which is a non-starter in Congress. Result: no reform.
Lew’s Inversion Perversion
Now Obama’s tax reform negligence has turned into a crisis, as one company after another acquires a foreign firm to do a tax inversion that will permanently raise its return on capital—and likely its PE ratio—by lopping about 1000 bps off its tax rate. This is not a new phenomenon; Wall Street nerds, myself included, have been discussing it for about six years. But the trickle has become a flood as more and more companies invert A) because they decided Obama will never reform taxes, B) to remain competitive with industry peers that have already done it, C) to get it done before a punitive preventive measure is passed.
Having belatedly noticed the inversion flood, which could become a tsunami, Treasury Secretary Lew wrote a letter to Democratic Senators on the topic. He starts out by noting that “the President has called for undertaking business tax reform as a way to improve the investment climate.” Which is true—Obama “called” for reform but did nothing to make it happen, like compromise with Republicans. Then Lew asks for a stop-gap measure to prevent inversions, even though it would become a barrier to comprehensive reform. Echoing the sophomoric rhetoric of his boss, Lew opines, “What we need as a nation is a new sense of economic patriotism, where we all rise or fall together. We know that the American economy grows best when the middle class participates fully and when the economy grows from the middle out.”
Lew knows this proposal will get nowhere. He is simply trying to turn a policy failure into a campaign issue for Democrats. But his letter goes far toward explaining why we have a crappy economy and high PE’s. Companies have managed to protect themselves from regulatory incompetence with such moves as inversions and low capital investment that limits capacity growth and protects profit margins. This helps shareholders but not average workers, who are hurt by Obamacare, the War on Coal, higher tax rates on entrepreneurs, etc. Consequently profits as a share of GDP are near record highs while the Fed’s zero-rate policy keeps valuations high. Wall Street flourishes while Main Street struggles—not exactly the “hope and change” Obama promised in 2008.
Maybe the Grass Really Is Greener in 2017
The good news is that Obama leaves office in thirty months (but who’s counting?). Hopefully his successor, even if it is Hillary, will adopt policies that promote rather than hinder economic growth. Then the Bianco Golden Ratio will move up, justifying elevated PE ratios even if interest rates are higher than they are now.
Copyright Thomas Doerfligner 2014. All Rights Reserved.