The advance in stock prices can be attributed to essentially 3 conditions. (1) A recovery in the U.S. economy, albeit feeble; (2) The Euro zone has calmed, at least temporarily and; (3) The easy money policy of the Fed that is artificially suppressing interest rates, for now. It is Fed policy that has been, in our view, the most powerful catalyst driving the equity markets. Notwithstanding current stock market levels, there are many who assert that the overall market is cheap. We are less confident in this assessment.
It is critical to remember that while we direct our “worrying concerns” to the macro, we invest on a discrete individual security level seeking specific companies that are selling for compelling discounts from their appraised enterprise value. “In other words, our purchasing decisions are governed by the specific fundamentals of companies. Our assessment of the overall market or economy has virtually no influence on our purchasing decisions.” The purpose of today’s discussion is to highlight the prospect of a highly disruptive market at some future date and to prepare you for these possible disturbances – and, of course, to underscore that such disruptions provide for the most compelling buying opportunities.
The Price Earnings Ratio
There are those who are asserting that the U.S. stock market is cheap and they are pointing to the current Price Earnings Ratio (P/E Ratio) to bolster their case. Others are pointing to the same ratio but are coming to the opposite conclusion. How could this be?
The two components of the P/E Ratio are “price” and “earnings.” Prices are easily ascertainable and there is no debate. Earnings, however, are open to interpretation. For example, one can use “operating” or GAAP earnings, forecasted earnings, or trailing earnings; and if one uses forecasted or trailing earnings one can use different time periods, the last quarter, the last year, etc. Many other adjustments are also possible.
The two most common ways to view the P/E Ratio are by the “conventional” measure which is based on 12-month trailing earnings. The second is the Shiller P/E which uses a 10-year moving average of earnings to smooth the impact of the business cycle. If we look at the S&P 500, the conventional P/E is expressing about a 15X multiple which, by historical measure, is “fairly” priced, or at least not overly expensive. The Shiller P/E, however, is weighing in at 24X, a level which is, historically, expensive. This is a surprising divergence and begs closer examination.
Investor and market commentator James Montier is a member of GMO’s Asset Allocation team. In a report penned by Mr. Montier in April of 2012, Montier asserts that the two averages are not as divergent as they appear. Mr. Montier begins by explaining that profit margins are generally at historically high levels and, in many cases, record high levels. Montier additionally points out over the past 60 years net investments were the primary engine that drove profits.
Today, according to Montier, government spending is carrying the lion’s share of what are driving profits. The question quickly transitions to the sustainability of government spending. Montier believes that government spending is not sustainable and he concludes that at some point profit margins will revert to their historical mean. When this happens the conventional P/E Ratio will reflect the expensive market already depicted by the Shiller P/E. Montier further asserts if one were to buy the S&P 500 at today’s levels the expected return, over the next seven years as implied by the higher P/E Ratio, would be roughly zero.
In the 22 November 1999 issue of Fortune Magazine Warren Buffet expressed a variation of the foregoing reasoning: “Today, staring fixedly back at the road they just traveled, most investors have rosy expectations. A … survey released in July shows that the least experienced investors – those who have invested for less than five years – expect annual returns over the next ten years of 22.6%. Even those who have invested for more than 20 years are expecting 12.9%. Now, I’d like to argue that we can’t come even remotely close to that 12.9%… In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.
“… Maybe you’d like to argue a different case. Fair enough. But give me your assumptions. If you think the American public is going to make 12% a year in stocks, I think you have to say, for example, ‘Well, that’s because I expect GDP to grow at 10% a year, dividends to add two percentage points to returns, and interest rates to stay at a constant level.’ Or you’ve got to rearrange these key variables in some other manner. The Tinker Bell approach – clap if you believe – just won’t cut it.”
For those who champion that the worst is behind us and earnings are rightfully robust, I would point out that even the most optimistic commentators are not arguing that the Eurozone’s massive problems are fixed; that the U.S. has not, even remotely, repaired its structural balance sheet issues and that over time our anemic recovery will stall… and that our profligate, reckless, and indecisive political policies must ultimately come home to roost. The unanswerable question is, “When will this occur?”
A Bubble of a Different Sort
Fed policies notwithstanding, the tens of millions of consumers who, daily, vote with their dollars in the real economy have shown small appetite for cheap money. Consumption remains weak and unemployment remains high. Speculators in the financial economy, however, have embraced the Fed’s largess and bid up “risk” assets. (The real estate market also appears to be heating up, particularly in the San Francisco Bay Area.)
Think about the implications of this: the most critical spending in the real economy are investments in new or additional plant and equipment, and the hiring of additional employees. These are the investments that have the potential to expand the economy and create wealth. Regrettably, such investments today are being apportioned with an eye dropper.
Consumers, and those who own and operate businesses, seem to be uncertain of our economic future. Consumer spending is therefore restrained, and business owners and operators are not investing nor are they hiring additional employees. Speculating in equities and junk bonds, which adds nothing to the economy, is alive and well. Interestingly, it is this speculation that seems to be the (unintended?) result of Fed policy. I put a question mark after the word “unintended” because some commentators are asserting that Fed policy is, in fact, intended to incite speculation, hoping to create a “wealth effect” to encourage consumption.
In the 12 November 2012 edition of Pension & Investments Drew Carter reported, “Institutional investors are tuning to riskier assets to improve performance in the persistent low-yield environment, but they are doing so without dramatically increasing the risk level of their overall portfolio.” I demur. The risks assumed by these impostor institutional investors are opaque, far-reaching and significant.
If we are in a bubble it is not the variety typically characterized by a speculative orgy fueled by greed and envy like we saw during the tech madness of the 1990s (which ultimately ruptured in March of year 2000). This bubble is almost at a polar opposite extreme, a bubble fertilized by the Fed’s engineered low interest rates which is characterized by a grasping for return. Desperate for yield, investors have been pouring money into high-yield bond funds; 2012 inflows into high-yield funds more than doubled the previous yearly high set in 2008. As a result, junk bonds experienced gains as yield plummeted to all-time lows in late 2012 and up to this writing. As the perceived risk dropped global equities surged, in sympathy, in an almost frantic quest for return.
When the aggressive policies finally work no longer, and market forces overwhelm the actions of central banks worldwide, those who were most aggressively reaching for return, and the opaque attendant risks, will likely experience the effect of a crushing market decline.
What is the Fiscal Cliff?
The term “fiscal cliff” is a political fabrication designed to coerce and posture by casting aspersions to those whose policies were at odds with a particular view of the world. Those who were threatening a fiscal cliff were posturing to declare “I told you so” if things work out poorly or remain silent – or even take credit! – If things work out well. Political expediency is the art of putting off until tomorrow that for which another politician will be held responsible. Here’s the reality. The economy will, at some point, purge the accumulated excesses resulting from the Fed’s policies of the past 30+ years – and the threatened fiscal cliff will “arrive.” When this happens you can expect a chorus of “I told ya so” coincident with well-orchestrated finger pointing.
Targeting the top 1% or 2% of the population to promote the illusion that this is how we will solve our fiscal ineptitude is morally outrageous. That my neighbor has four cars, and I have but two, does not give me a license to steal one of his to even the score. Our anemic economic performance has all the markings of a “perfect storm”: out of control government spending and gross governmental inefficiencies; inept politicians, economists and bureaucrats; and an ignorant electorate who want simple solutions to complex problems. The potential economic outcome is alarming and will end in tears for most.
Until we, as a nation, accept the harsh reality that no government can forever live beyond the collective means of it citizens, and that no government can engineer uninterrupted economic growth, we are doomed to repeated bouts of booms and busts. The combination of fiscal stimulus and structural deficits has resulted in our gross federal debt climbing from approximately 64% of GDP in 2007 to an estimated 105% today. A “fiscal cliff” is looming and its seeds were sown long ago, fertilized by misguided, selfish, political agendas and carried out by the misguided policies of the Fed. Unfortunately, it appears that we have exhausted all the less painful alternatives to right the economic ship of state. In effect we are faced with something analogous to a “prisoner’s dilemma.”
No country can save its way to prosperity via austerity, nor can it spend its way to prosperity via debt accumulation. At best we can only postpone the day of reckoning, but not forever. I believe Fed policies can be viewed as the American people having been first seduced, and then involuntarily forced to check into the “Hotel California.”
Fed policies seem to have created the belief, at least in the developed world, that there will always be some governmental entity to provide a safety net. Investors seem to believe quantitative easing will always be there to bail them out. I have a hard time understanding how our economic situation can end in any other way other than through some combination of massive defaults and inflation. The vanquished will be many.
The members of our political elite, including our President, are presented with many opportunities to place the interests of their constituency above their own. I am dismayed by their behavior.
We began this discussion by explaining that despite the “conventional” P/E of the S&P 500 weighing in at about a 15X multiple – a multiple that is not excessively expensive – that this ratio, seen in isolation, fails to reflect record high profitability and presumes that this profitability is sustainable. We believe the Shiller P/E is more accurately reflecting an unsustainable profit experience, and that such a high P/E multiple bodes poorly for the overall market at some point in the future.
Here’s how investor/commentator Chris Leithner, of Leithner & Company, summarized the illusion of current profitability in a recent white paper, “Why is profit presently at a record high? Because private domestic fixed investment stands at an all-time (since 1947) low; the supply of money as a percentage of GDP has reached a 40-year high; the government’s deficit has scaled unprecedented heights; and the government’s debt relative to GDP has returned to a level unknown since the Second World War. In short, the sickness – and NOT the strength – of the U.S. economy explain why profit has attained an unparalleled level. Capitalists’ saving, investment and pursuit of profit is the key to a higher standard of living. Their achievement of very high profits, on the other hand, reflects their fear of the future, particularly of the actions of the state (which Robert Higgs dubs regime uncertainty). Reisman shows that a high rate of profit does not reflect a healthy pace of economic growth. Quite the contrary: it is a consequence of harmful circumstances – particularly unprecedented doses of the state’s monetary interventionism and fiscal profligacy. The mainstream does not grasp the fact that the existence of high profits is not (from the point of view of society as a whole) economically beneficial. It does not realize that to a significant extent the profits of recent decades are – because they derive from the government’s deficits and inflation – artificial and fraudulent…”
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