Deutsche Bank\u2019s ace stock market strategist David Bianco\u2014a friend of mine and formerly a colleague\u2014has 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:<\/p>\n
Yr\/yr percent change in real GDP \/ Yr\/yr percent change in CPI<\/p>\n
David reckons that when that ratio is 1.6x or higher\u2014for example, with GDP growth of 3.2% and inflation of 2%\u2014the economy is in good shape. At such times, he writes, \u201cproductivity 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.\u201d In general, PE ratios tend to be higher when these conditions prevail and the Bianco Golden Ratio is high. A few examples:<\/p>\n
Crappy Economy, High PEs\u2014Huh?<\/strong><\/p>\n Against these three earlier periods, the current situation is anomalous\u2014crappy 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.<\/strong>\u00a0 Despite this poor performance, PE\u2019s have averaged a fairly high 14.7x since 2011 and\u2014more importantly\u2014over the past year the S&P 500 PE averaged a lofty 16.9x<\/strong>.<\/p>\n So why are PE ratios high despite poor U.S. economic performance? That\u2019s 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.<\/strong> I still see no evidence Chair Yellen has figured this out.<\/p>\n Looking at the litany of regulatory blunders by the Obama Administration, arguably the most egregious is failure to reform corporate and individual taxes<\/strong>, 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\u00a0reform. Obamacare may be one of the worst laws in American history, but expanding healthcare access is a worthy goal.<\/p>\n On the other hand, refusal to reform America\u2019s antiquated corporate tax code \u2013 with its excessive rates and global incidence that force firms to keep trillions of dollars offshore\u2014is pure negligence<\/strong>, born of Obama\u2019s 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.<\/p>\n Lew\u2019s Inversion Perversion<\/strong><\/p>\n Now Obama\u2019s 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\u2014and likely its PE ratio\u2014by lopping about 1000 bps off its tax rate. This is not a new phenomenon<\/strong>; Wall Street\u00a0nerds, 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.<\/p>\n 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 \u201cthe President has called for undertaking business tax reform as a way to improve the investment climate.\u201d\u00a0\u00a0 Which is true\u2014Obama \u201ccalled\u201d 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\u00a0rhetoric of his boss, Lew opines, \u201cWhat 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.\u201d<\/p>\n 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\u2019s<\/strong>. Companies have managed\u00a0\u00a0to 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\u2019s zero-rate policy keeps valuations high. Wall Street flourishes while Main Street struggles\u2014not exactly the \u201chope and change\u201d Obama promised in 2008.<\/p>\n Maybe the Grass Really Is Greener in 2017<\/strong><\/p>\n The good news is that Obama leaves office in thirty months (but who\u2019s 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.<\/p>\n Copyright Thomas Doerfligner 2014. All Rights Reserved.<\/p>\n","protected":false},"excerpt":{"rendered":" Deutsche Bank\u2019s ace stock market strategist David Bianco\u2014a friend of mine and formerly a colleague\u2014has 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 … Continue reading