This is written by someone who sold virtually 100% out of stocks at Dow 13,000 in August-September 2007 with such confidence that even when the market went up 7-8% in the fall, had no indecision and argued with friends and relatives to get out when the getting was good. Except for tactical forays, yours truly has stayed out of stocks ever since.
Nonetheless, sentiment and fundamental factors are changing rapidly, and every type of investment has its time and place. Central banks across the world have led the creation of so much credit money that too much money has chased too few real assets, and thus too much of this credit money has stayed within the financial system, bidding up prices across the board. Bill Gross of PIMCO did a fascinating piece on this topic last year based on PIMCO research. Here is the money quote from this November 2009 piece:
Let me start out by summarising a long-standing PIMCO thesis: The US and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades.
In this regard, matters appear to have made a full half-circle from the 1970s and early 1980s, when credit money finally became so expensive (relatively scarce) that there was not enough money to support all the real assets (and related debt obligations) and so that the price of said assets, such as stocks fell far below fair value; see relevant time period in this chart from Andrew Smithers, which values the U. S. stock market both on an asset basis and on a 10-year earnings basis. By this measure, fair value on
the S&P 500 is not much over 700.Caveat emptor.
However, the stock market has been overvalued by these measures for quite some time, and I was lucky enough to have had substantial net appreciation of my stocks in that time. Is there a way to invest in stocks given their historical overvaluation?
Perhaps.
Even in 2000, at the overvaluation peak, it turns out that there were numerous types of stocks that bottomed as the averages were topping. These tended to be boring companies that investors started dumping when the average stock topped in 1997-8 as measured by the Value Line averages, which weight all stocks equally rather than by market capitalization. Such industry groups as homebuilders, basic industrial companies, and HMOs (hated at that time) hit what remain their decade-plus lows just as the glamor stocks peaked. It was as if investors were running to the left side of the ship, leaving those on the (safer) right side lonely and the ship tilting; then they gradually rebalanced the ship.
I used to joke in 1999-2000 that if the stock market were so all-knowing, what it was saying with Yahoo! at 100 times sales (not 100X earnings) and Cisco at well over 100X earnings (forget about the Internet companies that were not real companies), but with homebuilders at book value and very low P/E's, the future of America was that everyone would live in a little shack but have all the electronics known to man.
Unlike then, sentiment is far from ebullient; there is little irrationality about stock prices. This is not summer 1987 or all of 1999 re over-enthusiasm over a raging, overvalued bull market. Investors get it. If you have any doubt about whether investors are reading upbeat or downbeat headlines, here are the titles of the first several articles headlined at RealClearMarkets.com Monday (afternoon edition):
We Are On the Road to 70's-Style Stagflation - Jeff Harding, Minyanville
It's Really, Really Ugly Out There - Jim Cramer, TheStreet.com
How We Get Through This Terrible Mess - John Mauldin, InvestorsInsight
Hedge Fund Managers Feeling the Heat - Charles Wallace, Daily Finance
Will Housing Slide Drag Economy Down? - Gittelsohn & Willis, Bloomberg
The Housing Gold Rush May Be Gone for Good - David Streitfeld, NY Times
Cheery, yes? Do these make you want to buy stocks or sell them?
Things are hardly less downbeat on the sidebar at RCM, with the following capsule headlines seen there:
Stock Market
Slowdown Fears Hit Street
U.S. Stocks Retreat as Economic Concerns Overshadow M&A . . .
Economy
U.S. Mortgage Fraud On the Rise
Jobless Claims Unexpectedly Rise to 500K; Highest Since November
Leading Indicators Show Slowdown
CBO: Hard Economic Times Ahead
Numbers Point to Darker Outlook
Contrast the above with the headlines from 1999-2000, or 2005-7.
I am in the stagflation camp; I am not a deflationist though I believe there is a good chance that within the next couple of years we see yet lower yields on long Treasuries.
On that topic but on a global scale, the economist Andy Xie came out with the following article, with excerpts:
Inflation, not deflation, Mr. Bernanke
Commentary: World divides into ice-cold and red-hot economies
When the Fed or the European Central Bank tries to stimulate, they are actually stimulating the global economy as a whole. Water, no matter where it comes from, flows downwards. Stimulus, similarly, flows to where costs are low and banking systems are healthy. If you believe this logic, the actions of the Fed and the ECB fuel inflation and asset bubbles in emerging economies rather than stimulate growth at home. . .
Despite trillions of dollars in stimulus and a sharp one-year rebound in the global economy from the middle of 2009, the developed economies have virtually seen no employment growth. . .
We are seeing overheating in emerging economies. The stimulus is just working somewhere else. . .
There is a bright spot for developed economies from globalization. While their economic data tend to surprise on the downside, the corporate profits will surprise on the upside.
There is much more in the Xie article, which inter alia addresses Japan and gold/commodities. I want to focus on the final comment I have excerpted, about corporate profits. It is a good read.
In accord with Xie, I believe that increasingly it is looking as though the West has been outsourcing its price increases. Multinational companies are doing better than individuals in the West, as global wage arbitrage and healthier banking systems in the East combine to revert wealth to the mean between countries. Before the Industrial Revolution, China and India had a share of global wealth proportional to their populations.
Investors need resolution of an apparent paradox: in the face of such low bond yields, how can many of the biggest and best multinationals sell at 10X earnings, pay dividends higher than a 7-year Treasury note, and retire stock through net buybacks (i. e. exceeding options dilution) despite strong balance sheets and technological and other economies of scale that appear to make them far distant from GM's and AIG's fate?
What difference does it make to their "correct" prices if other stocks are overvalued, perhaps those of companies that are highly leveraged financially and dependent on cheap imports to sell to over-leveraged, financially stretched Americans? Or those such as homebuilders that are dependent on massive governmental subsidies to make money nowadays?
A partial answer takes into account the gloom that informed individual investors are at least now and then assaulted with. To sum up my point about the possibility that stocks are finally competitive with bonds, here is the title of a New York Times current article: In Striking Shift, Small Investors Flee Stock Market (to enter the bond market about 29 years into a record bull market).
Personally, overwhelmingly my portfolio is comprised of high quality muni bonds, shortish duration individually owned Ginnie Mae securities (full faith and credit debt obligations of the U. S. government), cash and gold (ETFs, primarily, owning only allocated gold). I have a very, very small amount of my capital in stocks, and every one of those is a very strong company. The stock market's overall chart looks dangerous to me and the current and upcoming hurricane season is the classic time for stock market collapses. So the following is not a day-to-day timing matter but rather part of a strategic discussion I am having with myself about where the best relative values in the public markets lie, to then tie in with technical timing factors if I see the greatest relative value in stocks despite all their negatives.
After the rebound following the early May "Flash Crash", I blogged that I thought that stock rallies should be sold. I am now thinking that certain types of stocks could now be bought at the current price, and that if the market takes a significant further tumble, more could be bought.
Here is some of my reasoning.
After each credit-induced boom for the last several decades, that which was overproduced and over-invested in helped fuel the next economic cycle. Thus the investment in energy, plus conservation efforts, helped fuel growth from the peak of the energy cycle in 1980 for the next two decades; and if one did not invest in energy or gold in 1979-81, one did great in the stock market thereafter for the next 20 years. Similarly, the boom in tech in the '90s fueled the current disinflationary economy and the resultant gains in productivity have been perhaps the one major force for the "good" sort of price decreases(as opposed to price decreases due to overproduction of homes due to the artificial boom). This overinvestment in houses and over-provision of credit may fuel restraint in housing price increases or further price drops as, just as in the 1980s with energy, too many dwellings face continued price resistance and may well drop in real terms, thus (I hope) freeing up real resources to be spent on more productive endeavors than a larger house filled with more large-screen TV's. Similarly, ongoing weakness of lenders should provide a real business advantage to financially strong companies, whatever their size.
My stock thesis incorporates the above points. Asia is the creditor to the world (plus oil exporters), leaving aside a possible China real estate bubble. (This status is where the U. S. was after its sound money-based amazing growth after the Civil War.) U. S. multinationals can both source from and sell to Asia and their stocks nonetheless sell in many cases for much better values than U. S. government bonds or the bonds of those companies themselves. The strong multinationals need no financing from weak banks, whereas start-ups or small fry will be constrained from challenging them, at least in the U. S. relative to prior eras. And these strong companies have pricing power in inflationary emerging countries, per the Xie thesis, and may use the U. S. consumer as a cash cow while continuing to reinvest the profits where returns are greatest (typically ex-U. S. these days).
Added to the above, I expect the Fed to continue to interfere with the free market and keep interest rates extremely low and below the rate of price increases. So every year one gets a (say) 3% dividend yield from a multinational rather than a 1% (say) return from a high-interest rate bank deposit (!), one is ahead of the game by 2%; and one has inflation protection and international diversification with stocks. At some point, assuming the economic world does not end, should not the market price of the stock move at least back to where it is today (or where it may drop to as the current structural stock bear market moves along), thus providing bond- and cash-beating returns to the buy-and-hold investor?
No guarantees, but the stock odds are looking better and better to me as bond yields continue to collapse (this is written Tuesday morning, Aug. 24) and stock prices also continue to descend.
Unlike so many high-tech IPOs in the 1990s that made vaporware or wanted to be the fifth online pet supplies company, and financial companies in the more recent boom that made bad loans and put bad assets on their books, the companies I am thinking about actually have strong or super-strong market positions attained by decades or even a century or more of competition; tend to both be raising their dividends while shrinking their shares outstanding and ideally also be increasing their tangible book value; and they actually make products that meet the real needs of real people or other companies. Now that the 7-year Treasury note yields 2%, the fact that it is non-callable no longer interests me.
Superb economists such as David Rosenberg point out that after the credit collapse of 1929-32, the long govvie bond fell to 2.5% in 1940. What I have not seen him point out, though, is that the CPI averaged 5.6% annually in the 1940s, and this was not just a WW II phenomenon. The CPI averaged 7.1% in 1947-9.
So with Fed and federal policies oriented to growth, bond yields were far too low to have been good investments. Even if one bought stocks at the beginning of 1940 and then endured a serious bear market, by the end of the decade, their dividend yields alone beat bonds, and the Dow moved up several percent a year on average in price as well.
"Don't fight the Fed" was Marty Zweig's dictum from the way-back. When both the Fed and the federal government, the two most powerful financial forces on the planet, agree that they want growth and consumer prices to rise, and are willing to do all they have done for that, why does one want to overweight 20-30 year bonds at near-record high valuations? Why not go with the flow? Sometimes, resistance to governmental desires is futile.
A 10X price-earnings ratio equates to a 10% earnings yield. A 14X P/E equates to a 7% earnings yield. Even a 20X P/E equates to a 5% earnings yield. So relative to ultra-low bond yields, stocks have fundamental support. Earlier, I provided ample evidence that at the very least, ebullience is lacking from the market.
So putting the above points together, I believe a case increasingly can be made for stocks that meet some or all of the following characteristics:
1. Financially very strong; net creditors/cash-flow positive;
2. Make products that enhance productivity/meet real needs of "unstimulated" consumers/are timeless;
3. Ideally be multi-national rather than U. S.-only;
4. Be as far as possible from the financial bubble-type industries (banks, homebuilders etc.);
5. Very strong free cash-flow generation;
6. Very strong market position;
7. Either be technically oversold or have a chart showing outperformance;
8. Own gold in the ground at a cheap valuation per ounce and not depend on investors to stay afloat.
Given the above stringent criteria, it may be clear that I am not especially bullish about the stock market as a whole and have a relatively short shopping list. Too many companies that simply lack many real assets and/or lack the staying power to ever provide an acceptable return on their current market valuation are hanging around. Too many institutions still are all-in on stocks, and too many companies that meet the above criteria lack sufficient underlying tangible asset value, whether said asset value be government bonds or bricks-and-mortar assets.
Even though we think of debt as "senior" in a company's capital structure, it is cooperative economic enterprise, and ownership thereof, that is the core societal "business" activity. Money-lending and credit creation are newer concepts than cooperatively engaging in productive activities. The modern corporation, and ownership of a piece of a well-run company with the characteristics listed above, may finally, once again, be beginning to make sense to investors so many years after the amazing 2000 bubble peak in the major averages given the paltry alternatives the authorities and the markets present to us today.
Copyright (C) Long Lake LLC 2010
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