## What Is the Rate of Economic Growth Implied by Current Equity Prices?

There is a standard joke among economists that equity markets have predicted about 10 of the last 5 recessions. As the joke acknowledges, equity prices embody predictions of future earnings and this implies that they also embody predictions of economic growth rates.

So, what is the rate of economic growth implied by current equity prices?

A good way to think about this is to consider why there is a difference between the current average dividend yield (annual dividends per share as a percentage of the current share price) and the real bond yield (bond yield minus expected inflation rate). This difference is required to cover two elements: the equity risk premium and the expected future rate of growth in dividends. If it is reasonable to assume that the expected rate of growth in dividends will be equal to the rate of economic growth over the longer term, the market’s expected rate of economic growth is given by:

y = (r – p) + x – d

where: y = expected real GDP growth rate;
(r – p) = real long term bond yield;
x = the equity risk premium; and
d = dividend yield.

So, it is a simple matter to calculate y if we know r, p, x and d. Unfortunately, however, there are a couple of thorny issues that need to be considered regarding appropriate numbers to use for the real bond yield and the equity risk premium.

When I last looked at this question (about five years ago) I decided that it would be more appropriate to use a long term average real bond yield than a current real bond yield. If the current bond yield is used, the results seem to become unduly sensitive to current monetary policy settings. In my calculations for Australia I used a real bond yield of 4.5 percent.

What rate of equity risk premium is appropriate? The equity risk premium is one of the few topics for which it could actually be reasonable to claim that if you laid all economists end to end, they still would not reach a conclusion. To cut a long story very short, I used the average equity risk premium implied by the relationship between GDP growth rates, average real bond yields and average dividend yields in Australia over the previous 20 years. This implied an equity risk premium of about 3.3 percent. (I am prepared to make available an unpublished paper discussing the methodology to anyone requesting it by email.)

When I did the arithmetic with the dividend yield prevailing in August 2003 (4.3 percent), I came to the conclusion that the expected real GDP growth rate for Australia implied by then current equity prices was 3.5 percent per annum. Since this was only marginally above the average growth rate for the previous 20 years, it did not seem to me to be unduly optimistic.

When I do this arithmetic now, with the current average dividend yield (6.6 percent on 18 November, 2008), it suggests that the expected real GDP growth rate for Australia implied by current equity prices is 1.2 percent per annum. That seems to me to imply that current share prices in Australia embody an unduly pessimistic view of longer term economic growth prospects.

Health warning:
There is a rumour going around among former work colleagues that when I was living off my earnings as an economic consultant I was heard to say, more than once, that free economic advice was not worth much. That rumour is true, but I have since changed my opinion. There is no truth at all in the rumour that I have been heard expressing the view that there are three kinds of economists: those who can count and those who can’t. I tried to say that once, but I ended up saying that I didn’t know whether I should be considered to be in the first or second category.

The inherently unstable, fundamentally unsound and immoral worldwide financial system organized out of intrinsically worthless debt has exploded into derivatives and imploded into a greater depression.  Several of the stronger voices in the financial press evade the D word which hangs over the world economy like the Sword of Damocles.

But Yahoo Finance! reports, “The Obama administration is asking Congress to extend its oversight of the financial system to include the shadowy market of derivatives, the kind of complex financial instruments that helped bring down the giant insurer AIG. … The global business world holds a staggering \$600 trillion of these [over-the-counter] contracts.”

The Obama administration is already doing everything they possibly can to intentionally exacerbate the greater depression.  The use of political debt-based currency is destined to either implode in a deflationary depression or explode in hyperinflation.  As the Treasury bubble predictably bursts interest rates will rise.  The bond market is trembling as recognition that a 30-year bull market is coming to an end.

DERIVATIVES

Wikipedia gives a fairly clear definition of a derivative.  ”Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else. … Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.”

Wealth can be either a tangible or financial asset.  Tangible assets have intrinsic value and can never become worthless while financial assets can.  Often times financial assets are subject to counter-party risk.  Counter-party risk is the risk of loss due to a counter-party’s non-performance and is contingent upon their financial ability to pay.

In the shadowy world of derivatives there are many counter-parties potentially liable for hundreds of trillions of dollars.  These derivative assets infect the balance sheets of many public and private corporations, local and state governments and other institutions.  Through the use of fair-value lying the value of the derivative assets is hugely overstated while the value of the derivative liabilities is hugely understated.  Even worse is that the contingent liabilities have no basis in reality because they are based on nominal market value and not notional value.

Credit default swaps insure against a counter-party failing to make their payment.  Currently premiums for credit default swaps are twice as high on British sovereign debt as Cadbury.  In other words, a company that makes chocolate eggs is a better credit risk than a major western government.

APPLICATION TO PENSIONS

A good example of a derivative is a pension.  For example, an individual works for Chrysler for 40 years and retires.  Chrysler agrees to pay \$2,000 per month for the rest of the retiree’s life.  The value of the pension is derived from the value of the underlying (Chrysler).

Chrysler will use actuarial methods under GAAP, which can now be based on fair-value lying, to calculate the estimated pension liability.  We will assume it is exactly 15 years or \$360,000 which would then be adjusted to the net present value which we will assume is \$150,000.  This nominal market value would then be carried on Chrysler’s balance sheet as a liability.

On the other hand, the individual uses their own method of fair-value lying to calculate the value of the pension.  They may be optimistic and overstate their expected remaining life span at 40 years and use a more friendly discount rate to arrive at a net present value of \$450,000, or three times as much as Chrysler’s valuation.

Viewing the balance sheets systemically there is an asset of \$450,000 with a corresponding liability of \$150,000.  But the value of that \$450,000 asset is also contingent upon Chrysler’s ability to pay and therefore subject to counter-party risk.

If Chrysler goes bankrupt then there is potentially at least \$300,000 of illusory capital in the financial system that evaporates.  Of course, some creative investment bank who has loaned currency to Chrysler may actually profit from their bankruptcy and the greater the disparity of illusory capital and real capital then the greater their profit.

GOVERNMENT HELPLESSNESS

During the great inflationary credit expansion the use of illusions, irredeemable government or central bank tickets, as currency in ordinary daily transactions has become universal.  Their legal tender status, which is in complete conflict with the United States Constitution, is massive government regulation and the chief cause of all the current financial problems.  By violating the supreme law of the land Congress has created this massive mess.

Now the Obama administration wants Congress to engage in more regulation and intervention.  But why would these costumed officials be able to fix the problem they created?  Indeed, the only real tools they have are either their little intrinsically worthless tickets, which function like their common stock, or their guns.

Indeed, if the Obama administration sincerely wanted to fix this mess then they would remove the 28% tax on gold and then repeal the legal tender status of the FRN\$.

The common stock of America’s owner has recently declined to around 82 and is looking increasingly unattractive.  As Vladimir Putin observed “The only problem:  your results were poor and this will always be the case because the work you do is unfair and immoral.  In the long run immoral policies always lose.

But the truth of the matter is that the little tickets are subject to an incredible amount of counter-party risk.  Federal government liabilities are estimated to be around \$100T.  When the tax eaters and soldiers no longer get paid with currency that will purchase anything and the purchasing power in their pensions are gone then things will get particularly interesting.

CONCLUSION

The golden Sword of Damocles has begun moving because the great deflationary credit contraction has begun.  As the common stock of nations continues evaporating civil unrest will increase.  The greater depression will make servicing debt increasingly difficult and many derivatives will continue to trigger and decimate entities during this deflationary crash.  Confidence, already slightly eroded, will be completely destroyed as counter-party risk continues materializing.  Corporations and governments will DEFAULT resulting in complete worthlessness of those assets.  But who needs the dangerous costumed Washington clowns anyway?

Through all of this chaos and change there will be at least one brilliant asset.  At all times and in all circumstances gold is money.  Gold is the only major currency not subject to counter-party risk.  Gold cannot default.  Therefore, during deflation if the like-cash FRN\$ is king then the real form of cash, gold, is emperor.

Disclosures:  Long physical gold and silver with no position in TLT.