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The End Of (Artificial) Stability

By David Scott | Monday 12 March 2018


 


There are many ways of assessing the value of the stock market. The Shiller PE (price relative to the past decade’s worth of real, average earnings) and Tobin’s Q (the value of companies’ outstanding stock and debt relative to their replacement cost) are possibly the two best. That doesn’t mean those metrics are accurate crash indicators, or that one can use them profitably as trading signals. Expensive stocks can stay expensive or get more expensive, and cheap stocks can stay cheap or get cheaper for inconveniently and expensively long periods of time. But those metrics do have a good record of forecasting future long-term (one decade or more) returns.

And that’s important for financial planning and wealth management. Difficult though it is sometimes, everyone must use an estimated return into a formula for retirement savings. Stocks will almost certainly return less than their long-term 10% annualized average for the next decade or two given a starting Shiller PE over 30. The long-term average of the metric, after all, is under 17. Another way of looking at how expensive the market has gotten recently is to look at sales of the S&P 500 constituents and relate it to share price. Companies are always manipulating items on income statements to arrive at an earnings number. Recently, record numbers of companies have supported net income numbers with non-GAAP metrics. That can be legitimate sometimes, but on the whole companies use it to manipulate profits and share prices up. For example, depreciation on real estate is rarely commensurate with reality. But it can also be nefarious, as Vitaliy Katsenelson recently argued in criticizing Jack Welch’s stewardship of General Electric, which Katsenelson characterized as being more interested in beating quarterly earnings estimates rather than in creating long-term wealth. And that’s why sales metrics can be useful. They are less easily manipulated.

From the beginning of 2009 through the end of 2016, companies in the S&P 500 index grew profits per share by nearly 4% annualized, a perfectly respectable number for a mature economy. But price per share grew by a whopping 14.5% over that time. Over that 8-year period, sales grew less than 50% cumulatively, while share prices tripled. Anyone invested in stocks should worry how do share prices get so divorced from underlying corporate sales? One likely answer is low interest rates. But there must be other reasons because we’ve had low interest rates and low stock prices before – namely in the 1940s. That was after the Great Depression, and stocks were still likely viewed as suspect investments. Today, by contrast, stocks are not viewed with much suspicion, despite the technology bubble peaking in 2000 and the housing bubble in 2008. Investors still believe in stocks as an asset class. And yet, the decline in rates over the past four decades has been breath-taking, as has Federal Reserve intervention.

James Montier of Boston asset manager, Grantham, Mayo, van Otterloo (GMO), has studied stock price movements over the past few decades and found that a significant percentage of upward price movements have occurred on or before Federal Open Market Committee (FOMC) days. Montier estimated that 25% of the market’s return since 1984 has resulted from movements around FOMC days. Moreover, the market has moved higher regardless of what the FOMC decision was. If this is a stock market bubble – and the data shows unusually high prices relative to sales and earnings – it is a strange one. One doesn’t hear the anecdotal evidence of excitement – i.e., cab driver’s talking about their latest stock purchases, etc.…. This is perhaps a kind of dour bubble, where asset ownership at any price seems prudent in an economy that is becoming less and less hospitable to ordinary workers. Or, as Montier wrote in a more recent paper, this may be a “cynical” bubble where investors know that shares are overpriced but think they can be the first ones out when the inevitable decline begins. Most valuation parameters are either the richest ever or among the highest in history. In the past, levels like these were followed by downturns. Thus, a decision to invest today must rely on the belief that ‘it’s different this time.’ I’m convinced the easy money has been made.”

 

Most of corrections and crashes follow initial warning signals. Very often, market tops are followed by a few setbacks, followed by new highs, until the ultimate correction occurs. The 2000 dot-com collapse is a perfect example. The initial correction started on March 11, 2000, but the index didn’t bottom until October 2002 after losing 78% of its pre-crash value. Similarly, the Financial Crisis of 2008 and the collapse of Lehman Brothers were preceded by the 90% share price drop and subsequent bankruptcy of New Century Financial in March and April of 2007.The market peaked on October 9, 2007—a full six months after the initial shock. Then another five months later, Bear Stearns crumbled, followed by IndyMac in July 2008.

The Question You Should Ask Yourself

The question investors should ask themselves is: Which part of the cycle are we in today? Are we closer to a top or to a bottom? If we are closer to a top and we start seeing early signs of a correction, it’s important to adopt a defensive investment strategy before a more serious crash occurs. The market may still reach new highs, but the risks are mounting. Personally, I’d rather sacrifice a bit of performance to protect the downside. The reasons why we want downturn insurance in place now are:

  1. Stocks still have rich valuations today, especially the FAANGs. P/Es are high compared to historical averages.
  2. Over the last several years, corporations have used leverage for financial engineering rather than boosting productivity. US corporate debt levels are at an all-time high (above $6 trillion or about 31% of GDP). This excess leverage is fine when interest rates are low, but it can be deadly in a recession. In addition, stock repurchases don’t have the same impact on profits than capital investments.
  3. Interest rates are expected to increase because of the Fed’s tightening policies. Treasury issuances will likely increase over the next few years. Unfortunately, this may coincide with lower demand for US debt from both international and domestic buyers.
  4. Higher interest rates will put pressure on demand for consumer goods and real estate. These are two critical drivers of economic activity in the US.
  5. Many asset categories are currently in bubble territory and prone to downward adjustments: growth stocks, bonds, real estate in many markets, arts, collectibles, and luxury goods, and cryptocurrencies.
  6. Geopolitical risks are not insignificant (North Korea, Iran).
  7. Political gridlock in the US could lead to paralysis after the mid-term elections.
  8. Heightened risks of protectionism and trade wars.

There are some positive indicators that could prolong the current expansion—such as high employment rates and robust economic activity in all the developed economies. The Trump administration’s tax reform could also boost the economy, although most of the benefits are likely to be delayed. As far as I am concerned the risks when valuations are so full are simply not worth taking.

A branch of journalism that might be called, “don’t worry, be happy, because this time is different” tends to pop up at the peak of cycles when imbalances that caused past crashes start to reemerge. Eager to keep the gravy train going, business publications send reporters out to interview industry experts (who are making fortunes from the ongoing expansion) on why this batch of imbalances is no problem at all. And sure, enough they find all kinds of plausible-sounding rationalizations. In the 1990s dot-com bubble, for instance, stratospheric P/E ratios didn’t matter because for New Age tech companies earnings were “optional.” In the 2000s housing bubble record mortgage debt didn’t matter because home prices would always rise faster than the associated borrowing, keeping homeowners above water and banks ever-solvent. Subsequent events proved this to be nothing more than insiders trying to keep the deals flowing. Now, with pretty much every major indicator signalling a peak for the latest cycle, “don’t worry, be happy” is once again a popular journalistic beat.


As the world watches to see if Trump will follow through with his threat to put on steel and aluminium import tariffs, Europe continues to quietly ratchet up its own trade war with China. On Tuesday, as China was trying to define its future trade relations with the US, it was delivered a broadside from the European Commission after Brussels announced it had renewed tariffs on Chinese steel imports, some as high as 71.9%, saying producers in France, Spain and Sweden face a continued risk of imports from China at unfairly low prices. Ironically, that's the same thing that Trump is saying. The original measures, imposed last April, saw Europe setting anti-dumping duties on imports of hot-rolled flat steel products from China at a higher rate than the preliminary tariffs already in place. The European Commission explained it had set final duties of between 18.1% and 35.9% for five years for producers including Bengang Steel Plates, Handan Iron & Steel and Hesteel. This compared with lower provisional rates in place of 13.2 to 22.6%, following a complaint by EU producers ArcelorMittal, Tata Steel and ThyssenKrupp.

Last week Bloomberg reported that the European Commission reimposed for another five years the duties, which punish Chinese exporters including Huadi Steel for allegedly dumping pipes and tubes in Europe; the levies range from 48.3% to 71.9%, depending on the Chinese exporter. “The repeal of the measures would in all likelihood result in a significant increase of Chinese dumped imports at prices undercutting the union industry prices," the commission - the 28-nation EU’s executive arm in Brussels - said in the Official Journal; the five-year renewal will take effect on Wednesday. And even though China’s share of the EU market for stainless steel seamless pipes and tubes has been negligible, and hovering at around 2% since 2013, Brussels had no problem with pursuing what it thought was fair remedies.

The financial crisis, global recession and a long, slow recovery have dented public faith in central banks and it’s going to be a hard slog to win it back, according to the Bank of England’s chief economist. In a speech on Tuesday, Andy Haldane said credibility and trust are the “secret sauce of central banking” and there is no quick fix to regain them. That’s partly because of resentment among people about slow wage growth, faster inflation and the perception that whatever spoils the economy offers haven’t been shared equally. Over the past several years the largest buyer of U.S. treasury debt was the Federal Reserve through fiat money creation. That is printed money to buy the date of the government. Now, the Fed has tapered quantitative easing and is dumping their balance sheet at a rate faster than anyone expected. The Fed is pulling the plug on its artificial support of the economy. The next largest buyers are major foreign central banks in countries like China, Japan and to some extent the supranational EU. If the debt buyers of last resort are now the very same countries Trump is seeking to enact tariffs over, this is unlikely to end well.

They will dump U.S. treasury bonds pushing up yields and interest rates and perhaps even dump the dollar the world reserve currency. The Fed under Jerome Powell has made it crystal clear that they will be raising interest rates and cutting the Fed balance sheet, perhaps more than their dot plots had indicated in the past. Without low rates and a steadily rising balance sheet we have already seen the results. Stocks have gone crazy compared to the past few years, dumping nearly 10% one week, spiking about half that the next week. It is no coincidence that the first two times the Fed reduced its balance sheet the Dow plunged over 1,000 points. The latest dump of $23 billion at the end of February resulted in a drop of around 1,500 points. It is too early in this process to know what the trend will be, but it seems to me that stocks are being steam valve down every month. With a marked decline just after a balance sheet dump, followed by a less impressive dead cat bounce the week after.

One thing is certain, the supposedly endless bull market induced by the Fed years ago is now over. Investors are yet to wake up to this new reality and for most they will do so, too late and significantly worse off. Remember in 2006, everyone (please exclude me from this) from Ben Bernanke to Goldman Sachs thought 2008 was going to be a great year and we all know how that turned out!

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne


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