In an era of extremely low interest rates in most of the developed world, pricing the cost of equity capital becomes a real problem. When debt capital is close to zero, then equity capital theoretically becomes extremely cheap, too. The 90 day Treasury bill is at 0.24%. Translating that into an earnings multiple (by turning the interest rate upside down to make an earnings multiple, or price earnings ratio) that 0.24% translates an earnings multiple of over 400. In other words, on the standard ratio, companies can take over 400 years for profits to pay back their share value. That is an absurd result. But is it any wonder that equities seem overpriced in the US? A report by Morgan Stanley sounds a note of caution about the bullish sentiments in the market, arguing forecasts are too optimistic:
Developed-market earning forecasts look too high. Consensus expects a 30.8% increase in EPS between 2012 and 2010 (for the MSCI developed market index). EPS in 2010 was only 9% below the prior all-time high; earnings in 2010 were around the all-time peak once account is taken of dilution. In short, consensus expects 31% growth from a base of peak earnings.
An improvement in profit margins is one of the surprises. American corporates are cashed up and even enjoying pricing power. The finance sector has neatly socialised its losses, leaving government on its knees and the middle class under extreme pressure. But hey, business is good. Capital is cheap, profits are fine. The Morgan Stanley report says:
Corporates have seen a spectacular improvement in margins. As I’ve noted in hindsight (I did not expect this), profits saw a V-shaped recovery despite the tepid western-world GDP recovery. An unprecedented share of the initial recovery accrued to profits in the US. Exhibit 1 shows the four quarter change in gross domestic income, split between profits and the rest. Corporate profits accounted for all the increase in total income in the first year of recovery. Profits typically rebound faster than GDP in the initial recovery from recession, but never before has all of the first year of recovery fallen to businesses’ bottom line.
So let’s get this straight. The finance sector pulls of one of the biggest transfers of wealth in history (to put it as kindly, even inaccurately, as possible). This forces government to make money virtually free to stop the system from collapsing. Which means that business gets easy money and fat profit margins (oh, and the finance sector makes a fortune from the spreads). Bonuses return, business is good.
Who needs government? Or a middle class?