Yesterday, we looked at a discussion showing that stocks are relatively cheap.
However, that doesn’t mean they cannot get even cheaper; Today, we go to Scott Frew of Rockingham Capital Partners, who looks at that exact issue, and considers where stocks could go:
"Markets around the world rallied last week; this should not have been unexpected, given the length and severity of the recent decline. But I wouldn’t take yesterday’s action as a signal that it’s safe to get back in the water, and in the event that the rally continues for another week or two, I’ll use it as an opportunity to raise cash by selling more speculative holdings, and incrementally adding to short positions.
Pervasively bullish investors and commentators have puzzled over the market’s decline, searching to explain the seemingly inexplicable. They view the market as genuinely cheap, and the economy as sound and strong. One can always torture statistics (comparing forward operating earnings to trailing GAAP earnings, and the like) to make markets look cheap. But by the methodologies that have most consistently predicted future returns, Tobin’s Q and some version of a cyclically adjusted (adjusted to reflect the fact that earnings are enormously cyclical and mean-reverting) P/E, stocks are anything but cheap. The chart below is taken from Robert Shiller’s website, and uses trailing ten year earnings in order to adjust for the fact that we are, at the moment, in a period of unusually high earnings. As you can see, the market only looks cheap when compared to the previous peaks in 1929 and 2000. This does not bode well for future returns.
Trailing 10 Year Earnings
click for larger graph
Source: Prof Robert Shiller, Yale
To my view, the big issue is not why the market has fallen over the last several weeks, but rather how it has managed to stay as elevated as it is for as long as it has. The answers, I think, are threefold, all related, and all emanating from reason number one—the liquidity that has flooded the markets lo these many years, and particularly at every moment that has hinted at the possibility of severe dislocations.
Reason number two relates to the intense competitive pressures in the world of institutional investing. I know I’ve stayed longer in my small fund than I’ve wanted to be, feeling the need to squeeze every last basis point of return out of this dying bull, and the pressure only increases as funds get bigger. Witness that Iraq—Iraq!—was able to sell bonds at a 9% yield, and that even with the problems in stock markets around the world over the last several weeks, the junk bond market barely budged—spreads remain at record lows.
Lastly, the market is dominated these days by what I like to think of as “bull market babies”, which is to say people who have only invested since the early 1980s, and therefore have only known a world of falling interest rates and rising stock prices. The tumult the markets have experienced since that time have hardly been insignificant, but they’ve been swallowed up and overwhelmed by the larger secular trends toward lower interest rates and gushing liquidity. Investors have developed a touching faith in the ability of the central banks, magician-like, to pull one chestnut after another out of the fire—moral hazard reigns, and with it a hugely complacent view of risk.
But the world is changing, and our economy is not on sound footing. Bill Gross recently reported the comments of Charles Gave, who’s the opposite of a perma-bear, at Pimco’s just-concluded Secular Forum. “An economy dependent on asset appreciation which in turn is dependent on low yields, is more vulnerable than one based on income. … Gave then went further to suggest that changes in any one of the following five areas have historically had long-term influences on asset prices: 1) monetary policy, 2) protectionism, 3) taxes, 4) regulation, and 5) war.”
I’d say that all five of these forces are at least “in play”, to use Gross’ delicate phrase. The Gaves are also fond of noting that economic changes happen first at the periphery, moving from there to the center. The crashes in the Middle Eastern stock exchanges, and in Iceland, were indeed peripheral. The dislocations over the last several weeks in larger emerging markets, Russia, Brazil, and others, as well as in the commodity markets, move things closer to the center. (Let me note here that stock market bulls these days harp continually about the bubble in the commodity markets. Stephanie Pomboy noted in her most recent weekly missive that the CRB is up 44% since the beginning of 2003; the S&P is up 39% over the same period, excluding dividends. While there’s certainly been speculative activity in some of the commodities, I’m not certain those results are quite of the magnitude of Nasdaq 5000.)
The emerging markets sure seem like canaries in the coal mine to me. As John Hussman said in a recent commentary, expensive markets alongside rising interest rates is not a combination that, on average, has produced favorable stock market returns in the past. Dennis Gartman is fond of paraphrasing or quoting Grantland Rice to similar effect: The fight is not always to the strong, nor the race to the swift, but that is the way to bet.
As I said at the outset, rallies seem like great selling opportunities at the moment. I’m betting that our markets follow the lead of Iceland, Saudi Arabia, Turkey, Brazil and Russia. And that when the Fed comes again to our rescue, we discover to our dismay that when Mr. Greenspan went home, he took his famous put with him.
Frew is a general partner with Rockingham Capital Partners, a Long/Short Global Equity fund. Send him email here.