Rent generation throughout economic cycles

Key takeaway 

When the stock market seems expensive and valuations are "crazy", your ability to earn an income is increased and you have more to spend on buying rent generating assets. When the stock market is cheap and valuations are attractive, your ability to earn money is reduced but the rent generating assets you buy are worth so much more.

On stock market valuations and income

Valuations are rather lofty today using most indicators. Normally, such an "overpriced" market leads people to question wether or not they should hold off any equity investments and put their capital somewhere safer (where ever that is).

The above is, in my view, a limited perspective. You should not blindly fixate on your stock portfolio's potential returns/decline but instead look at the possibilities that are available to you as a whole. Let us look at two scenarios:

1. Market valuations are high, inflation is low, interest rates are abyssal and there are few options for rent generation outside of already highly valued stock markets, which continuously attract more and more risky capital from investors chasing a yield.
2. Market valuations are low, rates are at zero and there is massive QE being started to prop up the economy. Wide spread pessimism and unemployment rates are sky high.

Both scenarios present both challenges and opportunities. Both have happened in the past. Both will happen in the future. So, how do we navigate these two scenarios? In Scenario 1 you should not expect stellar long term stock returns. In fact, with a Shiller PE of 30.5 and a 1-year PE of 22.25 we should expect a long term yield that is far below the average 7.35% that the SP500 has returned in the past. In fact, yields are at a record low of 4.49% and dividends are at 1.88% (note that it is important to take into account the risk free rate, today's numbers are not particularly bad compared to historical numbers, but the yield is nevertheless low). 

Does these low yields mean that we should expect lower total returns going forward? The simple answer is no. First of all, noone has any idea of what the future will bring. There is good reason to believe that several productivity enhancing technologies will be introduced within the next decade as companies are exploring the data economy and revolutions in energy technology are made on a seemingly yearly basis. But let's stay pessimistic and assume that the yield will stay that low. Here it is important to remember that equity returns is just one source of wealth accumulation. During a Scenario 1 period, it is far easier to supplement income, e.g., run a low risk business such as consulting. Capital is abundant and companies seem to have an endless smorgasbord of new technologies to invest in; the appetite for investments into potential future business areas is at an all time high. 

Let's run the math. I'd argue that it is rather trivial for any profession with a desired knowledge base (e.g., engineer/programmer) to boost their income through a side job or by starting their own company. I argue also that one can easily bill KEUR 10 annually in a Scenario 1 climate (for comparison, that is about 10 days work with going rates in major European cities). Now, the corporate taxes hover around 10-25% in the EU, so we will use a 20% rate. That leaves you with KEUR 8 to invest into stocks through your company. With an average yield of 7.35%, KEUR 8 is equivalent to having a portfolio worth KEUR 109. So, in a Scenario 1 economy, you can boost your income with the equivalent of having a portfolio of KEUR 109 in an average economy. 

Let us do another comparison so that we can see how powerful this effect is. Assume you have a portfolio of KEUR 500 in an average rate environment. That would grow your assets by EUR 36'750 annually. In today's environment, KEUR 500 only boosts assets by KEUR 22'450. The difference of EUR 14'300 corresponds to about two weeks of consulting work. And keep in mind that consulting work is easy to come by in a Scenario 1 environment! For the ambitious, a Scenario 1 environment represents an opportunity to really boost incomes and accelerate long term growth; an opportunity that especially favors those who are young and without a big portfolio to begin with (and lose during a crash).

The second scenario is a bit different. Consultancy work will be scarce. This is where a stable job matters. Elsewhere, I have argued that having a stable job during the latter parts of an economic expansion is one of the wisest investment decisions you can make. As stocks come crashing down, you buy yield at a very cheap price, setting yourself up for long term performance and asset growth.

Do not focus so blindly on the current rates and valuations, you cannot time the market and these fluctuations are out of your control anyway. Focus instead on what you can do given the current economic environment you are in. Are valuations sky high and there are few available alternatives on the market? Great! Focus on consulting and figure out how you can leverage your skills to boost your income. There is no way you can time the market or tell what the future brings. Done right, you will be the busiest during the economic boom when everything is joyful and filled with hope, and you can relax when everyone else is panicking anyway ...