Look across the room you’re in, and imagine there’s a $100 bill taped in the far upper corner, where the walls and ceiling meet. Imagine you’re handing over some amount of money today in return for a claim on that $100 bill 12 years from now.
Drop your hand toward to the floor. If you pay $13.70 today for that future $100 cash flow, you can expect an 18% annual return on your investment over the next 12 years.
Raise your hand a little higher. If you pay $25.60 today for that future $100 cash flow, you can expect a 12% annual return on your investment over the next 12 years
Raise your hand just above chest-level. If you pay $39.60 today, you can expect an 8% annual return. Move your hand to the top of your head. If you pay $70.10 today, you can expect a 3% annual return. Raise your hand above your head. If you pay $78.90 today, you can expect a 2% annual return.
Now imagine jumping up and touching the ceiling with your hand. If you pay $100 today for that future $100 cash flow, you’ll earn nothing on your investment over the next 12 years.
The exercise you just did is the single most important thing to understand about long-term investing. I’ve often called it the Iron Law of Valuation: the higher the price you pay today for a given stream of future cash flows, the lower your rate of return over the life of the investment. As the price goes up, what investors considered “expected future return” only a moment before is suddenly converted into “realized past return.” The higher the current price rises, the more expected future returns are converted into realized past returns, and the less expected future return is left on the table.
Notice that the point where a security seems most enticing on the basis of realized past returns is also the point where the security is least promising on the basis of expected future returns.
While the Iron Law of Valuation will serve you well over the complete market cycle, it can make for a miserable time over shorter portions of the cycle. Here’s the wrinkle. Even if a security or market seems wildly overvalued, nothing prevents it from becoming even more overvalued in the near term, provided that investors are in a speculative mood. For that reason, we have to join the Iron Law of Valuation with what I call the Iron Law of Speculation: the near-term outcome of speculative, overvalued markets is conditional on investor preferences toward risk-seeking or risk aversion, and those preferences can be largely inferred from observable market internals and credit spreads (when investors are inclined to speculate, they tend to be indiscriminate about it). In the long term, investment outcomes are chiefly defined by valuations, but over the shorter term, the difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes has little to do with the level of valuation and everything to do with investor risk preferences.
One more Iron Law will help to put current market conditions into perspective. It’s what I call the Iron Law of Equilibrium: once a security is issued, it must be held by someone at every point in time until that security is retired. For example, every dollar of monetary base created by the Federal Reserve has to be held by someone in the form of base money until it is retired by the Fed. Buyers never put those dollars “into” the stock market without sellers immediately taking those dollars right back out. So the pile of base money “on the sidelines” never comes “off the sidelines” because it can’t magically transform into something else; it just changes hands.
Likewise, the Iron Law of Equilibrium says that there are never “more buyers than sellers” or “more sellers than buyers.” Every share of stock that is sold by a seller goes into the hands of some buyer. Prices aren’t driven up or down by “money flow” or a surplus of buying over selling. Prices are driven up or down depending only on who is more eager, the buyers or the sellers.
Together, the Iron Laws help to explain the mechanism behind quantitative easing. They also warn that because of extended zero-interest policy by the Fed, security valuations have advanced to the point where prospective nominal total returns on a conventional portfolio mix are likely to average well below 2% annually, with negative real returns, over the coming 12-year period.
Blowing bubbles – QE and the Iron Laws
Operationally, the Federal Reserve’s program of quantitative easing involves expanding the “monetary base” (currency plus bank reserves), which it does by buying up Treasury bonds and paying for them with zero-interest base money, which is a “liability” of the Fed. In effect, QE alters the composition of government liabilities, changing their form from Treasury debt to base money.
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