Thursday, January 21, 2010

Nouriel Roubini Should Stick to Economics, not Market Forecasting

In Roubini Says Global Stocks May Correct as Growth Disappoints, continues to publicize the market views of a top-tier economist who has built a large consulting business. The article begins:

A global rally in stocks may end in the second half of the year amid a muted recovery in the world’s largest economies and as deflationary pressures limit gains in corporate earnings, Nouriel Roubini said.

Failure to restrain asset-price bubbles in emerging markets, fueled by loose monetary policies in the U.S. and around the world, may also cause an “unraveling and a significant correction of asset prices which will be damaging to global and regional economic growth,” Roubini, the Harvard- schooled New York University professor who in 2006 foresaw the financial crisis, said in Hong Kong today.

At this point, the Roubini outlook as expressed in the article are quite mainstream.

Because they are mainstream, it is unclear whether even if events occur as he predicts whether markets are discounting this and will look forward even as a growth slowdown occurs.

What is most important in looking at markets is spying relative over- and under-valuation. A classic example involves March 2000. The NASDAQ peaked around 5100, having doubled in 1999 and gone up a bit farther in the new year. Fundamental measures of market overvaluation were at record levels, surpassing those of 1929.

Yet there were a great many industry groups that bottomed exactly when the averages popped. These groups were diverse and included homebuilders, HMOs, basic industry, and other out of favor groups. By mid-2002, if memory serves me well, the Russell 2000 was hitting record levels even as the averages were floundering. By the time the market his its double bottom in early 2003, many stocks had moved a great deal.

Toll Brothers, for example, bottomed in March 2000 around 4 and hit 15 little over 2 years later, ending 2003 at 20 (about where it trades today).

What had really happened was that the average stock, rather than the large cap stocks and the tech sector, topped out during the Asian contagion that began in 1997 and rolled on through 1998; it is those stocks that kept bleeding support and got grossly undervalued relative to the popular stuff.

It appears to me that a milder version of that has now occurred. One can look through Value Line and find company after company that is way off its lows, has a poor long-term chart, relatively weak financial strength, no dividend payment and none on the way, and a fundamentally rich valuation. One can also find strong companies with fundamental reasonable valuation, rising and record dividends, rising and record sales and earnings, and no reason not to have a reasonable expectation at least mid-to-high single digit returns to shareholders over a 5-10 year history. Relative to the market, they have underperformed the past year, but on a 2-year or 5-year basis, these companies have outperformed the stuff that I believe has moved too much.

These companies have been highlighted many times here. The list does not change much. Some, such as National Presto, have moved a great deal and are no longer cheap. Others, such as Teva, have not moved much. Everest Re, trading around book value, was up yesterday despite the general sell-off.

There are a series of poor investment choices available due to the general inflation of financial assets that Bill Gross wrote about in his December Pimco letter. This will cycle, but living in the present, we know that cash is being trashed but all bonds are increasingly risky given the explosion of debt combined with stagnant incomes.

The warnings of seers such as Nouriel Roubini are part of the chatter, no matter how right they are. Where they are most valuable is when they identify an evolving bubble or a seriously undervalued situation. Right now, the major imbalances - governmental deficits and money-printing are well known (don't sell gold). Unsexy stocks such as Chubb, Everest Re selling at single-digit P/E's and yielding over 2%; discount retailers with low double-digit P/E's and huge free cash flows; Teva and other special situations; and others provide inflation protection yet can do well in a no-growth economy. Over time these financially strong companies that have proven themselves winners over many years tend to continue to be winners.

Nothing in Nouriel Roubini's outlook have any special relevance to my willingness to hold all the above as part of a diversified portfolio. Until he develops more market experience, he would be well advised to stick to getting the economics correct and letting his clients adjust their market expectations accordingly.

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