Friday, March 11, 2011

Why this market is stalling out

So, many stories this week have highlighted that we are at the 2 year mark of an incredible bull run for US equities.  Mind you, at time of this writing, the Dow recrossed the 12,000 mark, which it lost yesterday, leaving it up about 3 percent from the Jan 2000 high of 11722, which, to my mind, still marks the top of the bull market.

For eleven years now, we have essentially gone nowhere - except to get some dividends.

Of course, if you traded in this market, or kept buying through the 2000-2002 crash, and then sold in 2007 or 2008, you did pretty well (provided you weren't heavily invested in Qualcomm or Nortel in 1999).

But where do we go from here?  Indications on several stocks are saying - earnings are strong, the bull should continue.  Other people, like Charles Nenner, believe things are heading back down from here.  I have believed in a double dip in equity prices, because lots of fundamental research I have read suggest that bull markets begin when valuations, as measured by P/Es, are below 10.  We are definately not there today, which means that we have another leg to go before we can build another bull market.  It is possible that this won't be as sharp as the 2008-2009 crash.  It might not be as deep, either, since P/E can fall if prices decline modestly and earnings increase.  This would be much like the late 1970s, when, earnings growth was rapid (becuase of inflation) but multiples contracted (because investors demanded a short payback period on investments to compensate them for inflation).

P/Es cycle between periods of low valuation and high valuation.  The primary driver is actually inflation expectations, which are highly correlated with interest rates, which in turn is highly correlated with Earning Yield (the E/P ratio).  If we imagine three scenarios for inflation: high, low and deflation (negative inflation), we would expect that in periods of high inflation, earnings yield would have to also be high, as an investor wants a quick payback of capital, which is depreciating in purchasing power.  High earnings yields mean low P/E, by definition.  Similarly, in deflation, investors are concerned that earnings growth will be flat or negative, as cash flows from fixed investment decline, even as historic cost keeps depreciation expense high.  True enough, the purchasing power of those dollars is higher, but they represent a possible loss of capital.  Thus, in periods of deflation, investors, perhaps suprisingly, also expect relatively high P/E - to compensate them for the risk of capital loss.

It is only when inflation is low and stable that P/Es are high - one might think of this as the Goldilocks scenario: low inflation means that investors can expect rising earnings over time, but low inflation means that repayment can be streched over years.

Crestmont Research has a paper which shows that P/Es in periods of low inflation, such as we have experienced over the past few decades, are high.  Incidentally, they also recognize that annual earnings, as in Net Income, is a volatile metric, and much like Professor Shiller, they have adopted a smoothing methodology - they look at earnings in comparison to GDP, and use changes in GDP to smooth the results.

I have written about the close link between GDP and Corporate Earnings as well.

What they find is that in an environment such as we currently are experiencing, a PE of 22, somewhat above their smoothed 19.5 would be in order.  Together with Earnings growth in the S&P500, they see equity prices around 1640 in 3 years time.  A nice return, to be sure.  Somewhat more sanguine than my expectation, though note that looking out five years, they are expecting only about 7.1%.

Note also that this is something of a Goldilocks scenario - with the level of inflation remaining low.

Many folks are expecting either much higher inflation (or in some cases deflation).  If either of these eventualities took hold, earnings yields would defnately move higher, and prices would fall, as might the rate of corporate earnings growth.

My own expectation is for more inflation, because inflation is the easiest form of default for any government, and EVERY major economy's government is facing a scary, scary deficit picture.

So - what to do?  I am looking at a few investment opportunities, cases where companies have solid dividends good exposure to many world markets (and are therefore naturally hedged against currency risk), well managed, with good franchises, and in a position to raise prices in the event of inflation.

Still, I have to say, I am really quite unsure about this market.

Welcome thoughts from others....

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