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Stargazers
We may be living through the early stages of a "historically unique period."
In the context of the unobservable neutral real Fed funds rate, it'd be the second such period in a row.
"Just as the post-GFC economic environment may have been a historically unique period that depressed r-star, the pandemic period could equally be a historically unique period that has temporarily lifted [it]," Deutsche Bank's Matt Luzzetti and Matt Raskin wrote, taking a deeper look at what's quickly becoming a hot
While I barely know what r-star is, my takeaway is that the odds of rates going even higher than 5.25% – 5.50% are growing. If and when one can peacefully clip a riskless and tax-advantaged coupon of 6%, or gasp 7%, how will that affect the appeal of the daily chop show? It is already a struggle to find enough names with probable double-digit upside to fill a portfolio. When you find them, they deliver that upside in weeks, presenting the short-term gain conundrum. Those that you hold, when you re-run your valuation models a few months later, any upside has been eroded by higher riskfree rate. @derek used the phrase “picking up pennies in front of a steamroller”. Even picking up dollars in front of a steamroller is enervating.
Many years ago (at 78, pretty much everything in my life was many years ago) a really smart lawyer called me and asked if I’d ever acted as an expert witness in finance, specifically in valuation. I said no and he asked if I like to try it. So I did and this practice became my second biggest side gig. Over the years I did nearly 100 cases, half of which required my testimony; the rest ended on the courthouse steps. So here’s the sticky part. Value problems require estimates of the present value of unknown cash flows at an unknown rate of interest. However, courts require all testimony to be: “the truth, the whole truth and nothing but the truth.” Even after testifying dozens of times it still scared the crap out of me to take that oath. I knew from the get that nothing I said could be proved to be the truth, by any one alive. Everything was based on estimates, aka, guesses. The cash flows were often fairly easy to estimate, as long as one could forget about inflation, anyway. The discount rate, “i,” was another story. As one can see from the multi-process graph for finding r* that H posted here, there is nothing certain about any of this so I had to do my own chart. After much research, I settled on 2.5% as a real rate that most closely resembled and acceptable average over many decades. This was a good choice from years of data and since it was a real rate I could ignore future inflation for the cash flow estimates. Using say, 5% inflation for the future flows would mean using 7.5% for the rate. This means one had to make two dicey estimates. With history as a guide, indicating a 2.5% real real rate, implied less sacrifice of the “truth.” Never once when approaching the problem this way did any expert for the other side object to this approach. So my conclusion is that if r* can be known, I like 2.5% the best. Since we may not be as high as 1% yet, there is room at the top.