Sunday, 19 December 2004

Kasriel's Christmas commentary

Paul Kasriel, director of economic research for The Northern Trust Company, wrote his last commentary for the year on 16 December. Some gems:

Flow-Of-Funds Stocking Stuffers
On December 9, the Fed released its flow-of-funds data updated through the third quarter of this year. Herewith are some "stocking stuffers" fashioned from these data.

... In the two quarters ended Q3:2004, the 30-year mortgage rate increased a minuscule net 29 basis points (based on quarterly averages of interest rates). But in that same period, an index of housing affordability declined by 9.44% (not annualized). Maybe this is why adjustable-rate interest-only mortgages are becoming so popular. Even with relatively low 30-year mortgage rates, many folks are not finding homes affordable given the sharp rise in the value of residential real estate...

In recent years, households have joined with the government in being net demanders of funds from the rest of the economy -- U.S. and global. That is, we now spend more than we earn, making up the difference by borrowing or selling off some of our previous saving... In the four quarters ended Q3:2004, households' net demand for funds averaged about $241 billion. How else were we going to pay for all of those SUVs, plasma TVs and McMansions? What is so remarkable about households being net demanders of funds now is that so many of them are baby boomers who have entered their prime saving years. One would think that as the retirement finish line is coming into view for these baby boomers, they would be stepping up their financial saving, having already bought their McMansions...

... [I]n the third quarter, household debt as a percent of the value of total household assets -- tangible as well as financial -- increased to 17.4%, just shy of the post-WWII high of 17.5% set back in the first quarter of 2003. Mind you, households' debt-to-asset ratio went up despite the fact that the value of their houses rose by a record amount.

... Curiously enough, after decades of being net demanders of funds, nonfinancial corporations have become net providers of funds to the economy. That is, corporations are not spending all of their after-tax after-dividend cash flow on capital equipment and inventories... What makes it especially unusual is that the cost of capital -- be it equity or debt capital -- is so low now. This suggests that the expected return on capital in the U.S. might be unusually low now.

... In the late 1990s, there was a surge in foreign direct investment in the U.S. Foreign entities were building factories in the U.S. and buying up U.S. corporations. That was a genuine demonstration of confidence in the American economy. All right, it was a mistake, but it still was a genuine vote of confidence. In recent years, foreign direct investment has been replaced with foreign official (foreign central bank) financing of our external deficit. This foreign central bank financing of our external deficit is not a vote of confidence in the American economy. Rather, it is a manifestation of Asian mercantilism...

What may be of most direct and immediate relevance to stock investors is his statement: "the expected return on capital in the U.S. might be unusually low now".

Investors usually accord a higher multiple to stocks when interest rates are low, since the discount rate is also low. However, if the return on capital is low along with interest rates, conceivably, the earnings growth rate would also be low, possibly even be negative. Under such circumstances, there is no reason to accord a higher multiple to stocks despite the low interest rates. This in turn implies that stocks in the US may not be undervalued, as claimed by many, especially those who use the so-called Fed model of stock market valuation.

From what I can see, however, this is a possibility that many analysts and commentators don't seem to want to face up to.

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